Costly 401(k) Mistakes that Could Wipe Out Your Retirement Plan

We were recently asked to help someone who had a very unusual problem with her 401(k). While the combination of problems was unusual, the situation illustrated several common mistakes people make. In this case, the combination of mistakes compounded into a nightmare. Hopefully, after reading this article, you’ll be able to avoid these same costly 401(k) mistakes.

costly-401k-mistakes-672x372Here’s a short synopsis of the situation: several years ago, her husband borrowed money from his solo 401(k) plan to purchase a building from which he ran his business. No payments were ever made on the loan. When they divorced, she accepted the building and the 401(k) as part of her share of the family assets in settling the divorce. He had refinanced the building to pay off the mortgage on the house, which he was to receive in the divorce settlement. She asked us what to do with the mortgage on the building held by the 401(k) plan.

Don’t lend to, or invest in, yourself through your retirement plan.

There are about three or four mistakes just in this one sentence. As the trustee AND beneficiary of the retirement plan, a business owner is a fiduciary to the plan, which makes him or her a “disqualified person.” Any ancestor or lineal descendant of that trustee is, too. Other relations like aunts and cousins can also be disqualified if they are influenced by the trustee. In essence, a “disqualified person” is prohibited from doing business with the retirement plan because that allows them to use the retirement plan assets without being taxed on them.

Several examples of prohibited transactions include:

  • Buying collectibles like art, rugs, jewelry or most coins
  • Buying life insurance
  • Buying alcohol or other tangible personal property
  • Lending money to a disqualified person
  • The sale, lease or exchange of property between the plan and a qualified person
  • Pretty much any act in which plan assets or income benefit a disqualified person, except a normal distribution to a plan beneficiary.

In the case above, a disqualified person (the business owner and plan trustee) lent himself money to buy a building. That he didn’t make payments on the “loan” compounded the problem, but is actually a fairly common mistake without automated payroll withholding; not making loan payments on your 401(k) loan. Not making the loan payment guarantees it will be treated as a distribution rather than a loan, and subject to tax and possible early distribution penalties.

If you make a mistake, fix it fast.

In the year that a prohibited transaction happens, the IRS will impose a 15% excise tax on the amount of the transaction. If it is not corrected in the year it happens, that becomes a 100% excise tax. Basically, your 401(k) plan or IRA stops being a retirement plan and is treated as having been fully distributed as taxable income as of the first day of the year the transaction happened. You will then owe taxes, penalties for underpaid taxes and interest on those taxes from that date. Making a mistake is expensive, but not correcting it is devastating.

Look at both the asset values and liabilities in a divorce settlement.

In the case above, the wife accepted – as part of her divorce settlement – a building with a defaulted mortgage and a 401(k) that wasn’t actually a 401(k) anymore. The husband got the family home while she was inheriting some very big business problems.

What’s the bottom line in this story? In all likelihood, the IRS will decide that the husband’s entire 401(k) should have been distributed and taxed in the year the original transaction happened. They probably owe several years’ worth of unpaid taxes and penalties on that alone, but that’s a question for tax and ERISA attorneys. And they might need to go back to the negotiating table for that divorce, since their assets probably aren’t what they thought they were.

“With a Qualified Plan like a 401(k) or IRA, the investments have to be viewed differently than a personal account because there are very complex rules involved. Transaction costs and appraisals for property and collectibles are already very high, and unwinding these transactions inside a Plan gets very expensive,” says Linda Podhorski, a qualified plan consultant with National Retirement Services, an Ascensus Company.

Investing in real assets in a qualified plan can be tricky and expensive. The rules are complex, and the penalties for non-compliance can be severe. Real assets, private placements and partnership interests require annual valuations that can be expensive.

At Blankinship and Foster we help you avoid costly 401(k) mistakes like this by coordinating investments with your tax, financial and life situation. We also work with your pension administrator and IRA custodian to help you avoid these kinds of prohibited transactions. Contact us to discuss how we can help you manage your investments and your finances better for peace of mind during your retirement.

About Rick Brooks

Rick Brooks, CFA®, CFP® is a partner of Blankinship & Foster LLC and is the firm’s Chief Investment Officer. He is a lead advisor, counseling clients on all aspects of personal financial management. Rick serves on several boards. He is the Chairman of the Board of Girl Scouts San Diego, and also chairs the San Diego Foundation’s Professional Advisor Council. Rick and his family live in Mission Hills. Rick enjoys spending time with his family, theater, cooking, skiing, gaming and reading.

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