There’s a hidden distinction among solo 401(k) plans from one provider to the next that’s big, bad and disconcerting if you discover it the wrong way. I’m Bryan Ellis. I’ll tell you what it is right now in Episode #254 (part D) of Self Directed Investor Talk.
Bryan Ellis: Welcome back, ladies and gentleman, to Self-Directed Investor Talk. In the last segment, we began a conversation with Tim Berry about the distinction between custodial versus trustee solo 401K plans. Basically, the distinction usually is that custodial plans are usually set up by self-directed IRA companies, banks, other places, brokerage companies, places like that. And trustee plans generally are the ones you control completely by yourself. There is a big, big distinction between those two that you need to understand because you probably have a misconception. This is based on a revenue ruling from the IRS that really, really throws a monkey wrench into the whole concept of solo 401Ks as being supremely secure.
Tim, what do you think?
Tim Berry: Well, this revenue ruling … and like you said, boy, does it ever throw a monkey wrench. Actually it throws a whole car into the whole thing. It's a real mess. It says that if you do something accidentally wrong with your 401K plan and it's a custodial 401K plan, sorry. There's no saving grace. The assets are fully distributed, you got a big, taxable event. End of story. Whereas, if it was a trusteed plan, you still have all the various safety nets that come with a 401K plan. So, it makes a super compelling argument about do not use a custodial 401K plan.
Bryan Ellis: That is huge. Now, look. That was a revenue ruling from 1971. One could plausibly think that that's been 40 years ago, almost 50 years ago now. Can you believe that? That's 1971, is almost 50 years ago now. Dear Lord.
Tim Berry: I try not to think of that, Bryan, because I was born before then.
Bryan Ellis: Yeah. Having said that, that's been a long time ago.
Tim Berry: Thank you, Bryan. Just tone it a little bit harder, would you please?
Bryan Ellis: I was born a little after that. That was a long time ago, Tim.
Tim Berry: Yeah.
Bryan Ellis: So the question is this: is that still relevant? Has anything come out since then to either refute or reinforce that?
Tim Berry: Yeah. Something's come out to reinforce it because that was even before the big change in all the pension plan laws that came out in '74. What happened is this revenue ruling was all based upon this one regulation section in the tax code. But that regulation section has been taken out and a new one in its place has been put in but it has the exact same language that was referenced inside the revenue ruling. So, while the revenue ruling is a bit long in the tooth, shall we say, it's a bit old, all of the language it references is still viable and still current in the tax code in the regulations.
Bryan Ellis: Very, very interesting. So, bottom line here is that this is a big reason to motivate a person to go with a trustee plan rather than a custodial plan. Now, how might they determine which kind of plan they have?
Tim Berry: Easiest thing is they probably have a separate set of documents called an adoption agreement. The adoption agreement is gonna have all sorts of fill-in-the-blanks and check marks. If that adoption agreement makes reference to a custodian and there is a name of a financial institution filled into that custodial area, custodian area, they probably have a custodial plan.
Bryan Ellis: And in that event, should they … is that a justifiable reason to make a change in the type of plan that they have?
Tim Berry: Gosh. I think it's an absolute no-brainer. I think you'd be foolish not to because the big benefit of the 401K is the safety net it provides. And now, if you don't have that safety net to a certain extent, it becomes why would you want a 401K?
Bryan Ellis: So, would it be possible for a 401K to be repaired? Or does it have to be replaced?
Tim Berry: You're probably gonna have to amend the documents, but that's all. It's a fairly easy process.
Bryan Ellis: Is that something that you can help people with?
Tim Berry: I'd be more than happy to help people out with it. But, Bryan, let's make a distinction here. That's not the purpose of this, for those people who think that there's some nefarious purpose of pointing this out. That wasn't the purpose of this call, this interview whatever. The purpose is to make people aware of it and now, do not get caught in the trap and I'm probably gonna get you in trouble, Bryan, for saying this. But, don't get caught in the trap of using your self-directed IRA custodian to set up a 401K because that's probably gonna be a custodial account and that's setting you up for a world of hurt. Don't do it.
Bryan Ellis: Couldn't have said it better myself. Thank you so much, sir.
Tim Berry: Thank you, Bryan.
Bryan Ellis: Okay, folks. That concludes our discussion with the great one, Mr. Tim Berry. If you need his help in correction your solo 401K, you can reach him. His contact coordinates are on today's show notes page at selfdirected.org/254d as is a link to the operative revenue ruling from the IRS that we have been dealing with today, selfdirected.org/254d.
Ladies and gentleman, we've got a doozy of a final segment coming up. We'll be right back.
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