The Risky World of Pensions

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7-16-3If you’re fortunate enough to still have a pension, chances are you’re wondering how to rebuild it. Will real estate come back? Is the stock market your best bet today? How about self-directed investing? What’s involved in charting your own pension destiny?

There are all kinds of ways to self-direct a pension, and the levels of self-directedness vary. For example, if you’re contributing to a company-sponsored 401(k) plan, your self-direction is likely limited to whatever stocks your plan administrator and custodian have on their list of approved investments.

If you go it alone, and contribute money to an IRA or a Roth IRA, you have more choice in how you invest the funds. There are plenty of custodians out there who will allow you to have a truly self-directed fund, where you call the shots.

7-16-2But the contribution limits for an IRA are low, and you can only have a Roth IRA if you make under a certain amount. That’s where small business owners, who have no full-time employees really have an advantage. The Solo 401(k) plans allow business owners to sock away up to $49,000 per year. If you and your spouse own the business together, you can double that amount, and each contribute $49,000. Of course, this assumes you’ve got the income to cover it – you can’t simply pay yourself $49,000 and have the whole amount contributed to your pension plan. But every dollar contributed to a Solo 401(k) plan is deducted from your pre-tax income, making for a hefty tax deduction.

There’s also a Solo Roth 401(k) plan you can set up. This is a little different – it’s funded with after-tax dollars, that must come from W2 or 1099 earnings, and you max out at $16,500. But that money also grows tax-free and comes out tax-free, plus there’s no income limitation. Doesn’t matter how much money you make – if your business qualifies, you can have a Solo Roth 401(k).

You can fully self-direct Solo 401(k) plans, too, depending on your custodian. But here’s where things get tricky. The more freedom you have to invest, the less you can rely on your custodian to keep things square. And that can lead to some awful results, particularly if you get caught up in a prohibited transaction or do something with a disqualified person.

7-16-4Pension investments are governed by strict IRS rules. Make a mistake and you risk having your entire pension plan disqualified, and taxed at your current ordinary income tax rate. It’s easy to make mistakes. For example, you can invest personal funds alongside pension funds, but only if the investment happens at the same time. If you put a down payment on a property using personal funds, you’ve just blocked your pension from joining in. Or, people want to buy a home for a relative. Some relatives are okay – you can buy a house for a sister, brother, aunt, uncle, cousin, etc. – but you can’t by one for a lineal relative (parent, grandparent, child, grandchild, etc.) Or people want to invest pension funds into a business they are currently operating. There’s a way to do it, but you’ve got to be very careful how – the more you participate in the business, the greater the chance that you’ll accidentally create a prohibited transaction.

All of these examples can be avoided if you use a good, reputable custodian to administer your pension. A custodian can be used as a sounding board, to make sure an investment is done properly. They can also take care of the tax filings that need to be done each year, plus make sure that your plan itself is approved by the IRS. But of course there’s a price for these services … and that leads to another issue we’re seeing. There’s been an increase in self-settled pension plans, where pension owners are also acting as personal custodians and administrators of the plan. You do save fees but at the expense of the safety net a professional custodian provides. Now all decisions are truly on you personally, along with all paperwork, all compliance filings, and so on.

7-16-1That’s not to say you should never use a self-settled plan. But do proceed with caution. Start slow and work with a professional custodian while you learn the ins and outs of self-directed investing. It won’t slow down your ability to invest in opportunities as they come up. Pension custodians move pretty fast when it comes to getting a check out for an investment. And it will allow you to make sure you’re getting the best advice possible before you make any investment decisions.

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