The exclusive benefit rule as it applies to self-directed solo 401(k)s
When considering the type of investments that you want and how they will be used in your self-directed solo 401(k) certain rules must be followed. One that is less commonly referenced is the Exclusive Benefit Rule.
The exclusive benefit rule stipulates that all activities of tax-sheltered retirement plans, such as 401(k)s and IRAs, must be for the exclusive benefit of the plan beneficiaries as stated in IRC section 401(a) and 408(a).
This rule should be examined in two ways:
· The plan’s investments must be held in the best interest of meeting the retirement benefit needs of the plan participant(s) and growing the savings amount.
· The investments held in the plan must grow the savings amount in the plan as oppose to providing a benefit to the plan’s beneficiaries or other disqualified persons.
To comply with the requirement to be in the best interest of the plan, the IRS recommends the following measures to determine if a plan’s policies are for the exclusive benefit of the plan participant:
· The cost of an investment must be less than or equal to its fair market value (FMV) at the time of purchase.
· A fair and customary rate of return on the investment must be provided (expected).
· The investment must be adequately liquid to allow distributions per the plan terms.
The protections and investment variety that a sensible investor would adhere to must be present.
· The protections and investment variety that a sensible investor would adhere to must be present.
If a plan acts, or is used, in a manner that delivers a benefit to the participant or an otherwise disqualified person, then a prohibited transaction has occurred.
When you choose a self-directed retirement plan, you are responsible for acting in accordance with these guidelines and following best practices to invest reasonably and judiciously for yourself as the participant.
A common situation when the plan could be at risk of violating the exclusive benefit rule is when dealing with a close friend or family member (who is not disqualified) but the investment is handled in a way that benefits the other person above benefiting the plan. For example:
- While giving a loan from the plan to a sibling (who is not a disqualified person) is allowed, if the interest rate is well below market rates, then it really isn’t an investment that is in the best interest of the plan.
- Comparably, if a friend were a tenant renting a property held in your Solo 401(k) and they were delinquent in paying rent per the (reasonable and normal) terms of the lease, you would need to evict them, just as you would any other tenant. If you didn’t, that would be contrary to the exclusive benefit of the plan.
