Have you ever heard of a self-directed defined benefit plan? Is it legal? If so, what are the pitfalls?
Alternative asset classes in retirement plans have become very popular in recent years. Every day we talk to investors out there who have defined benefit plans and want to invest in real estate and other non-qualified assets.
While real estate and other assets classes can provide exceptional returns to the plan, of course there are inherent risks. Each deal should be properly vetted and analyzed to avoid any downside to the investor.
The good news is that these plans can be self-directed. So you can invest your retirement funds in real estate and other non-qualifying assets.
But there are a few complications and pitfalls to avoid. In addition, you must have a third-party administrator (TPA) that is well versed in how these plans work. Let’s explore the details.
What is a self directed defined benefit plan?
Many taxpayers have heard of self-directed IRAs (SDIRAs). But many do not realize that a defined benefit plan can act in very much the same way.
Defined benefit plans are powerful retirement options. As the name implies, the defined benefit plan is an IRS approved retirement plan specifically for self-employed people or sole owners (and qualifying employees) of a business. They allow for large contributions and can be very tax efficient retirement solutions.
But how can you “self-direct” a defined benefit plan? The self-directed plan is a slight variation. It allows the business owner to be the trustee of the plan. This is the feature that allows for the self-direction of plan assets. This gives the business owner a very flexible structure.
What types of assets can I have in my defined benefit plan?
But first things first. This strategy only really works for owner-only businesses. This includes a spouse, but no qualifying employees. If the business has qualifying employees, the self directed plan is much more challenging to execute.
- Real estate. This is typically the most popular asset class. Valuation and securing non-recourse financing can often be difficult.
- Hard money loans and commercial notes. Acquiring non-performing mortgages or issuing hard money loans is another plan favorite. This can be risky because of note impairment. However, the interest income is generally not considered UBIT.
- Gold and precious metals. Precious metals and mineral rights and royalties in retirement accounts became very popular with self-directed IRAs. Many folks like these investments because they often run counter to the stock market and mutual funds. They can help diversify a retirement portfolio.
- Bitcoin and cryptocurrency. I don’t recommend bitcoin in a defined benefit plan because of volatility. The goal is to get a consistent return that is in line with the interest crediting rate.
- Partnerships and private placements. These investments come with a Form K1 that is generated from the partnership tax return. The returns can be good, but can have UBIT issues. Discuss these with your plan administrator before you invest.
The investment options are almost endless. But there are a few pitfalls and complications to consider. These usually surround annual valuations, bonding requirements, and 5500 filings.
Do I need an annual valuation?
Each plan requires an annual valuation. But there are not readily determined market prices for real estate like there is for stocks, bonds and mutual funds.
Since defined benefit plans require annual actuarial calculations, your TPA will need to have the fair value of the real estate and other assets. This is because the assets need to be sufficient to pay accrued benefits. If the asset value falls short, the company will need to make additional plan contributions.
Determining the annual valuation of all assets in the defined benefit plan at year-end is critical for compliance. So consider hiring an independent, outside appraiser for the job.
What about bonding?
When your plan has “non-qualifying” assets that exceed 5% of total assets, then you must maintain a fidelity bond for the combined value of all “non-qualified assets.”
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If you don’t have fidelity bond coverage or you let it lapse, you may lose your “small plan” exemption and could be required to have an annual plan audit. These audits are costly and time consuming.
Form 5500 requirements
ERISA typically doesn’t cover one person plans. You would then be filing Form 5500-EZ. However, if your defined benefit plan holds non-qualifying assets then you are required to submit Form 5500.
How do I open a bank account?
Banks are warming to the idea of self-directed defined benefit plans. In fact, we work with banks that can provide the following:
- Free bank account set-up
- Accounts can be set-up usually in 48 hours
- Free mobile check deposits
- complex structures including multiple nested LLCs and trust
- Free checks and debit cards
- Online banking with ACH and wire access
- Online application forms with minimal paperwork
- FDIC insured bank accounts
- Non-recourse loans on real estate
| Pros | Cons |
| Flexible Investment Options | Valuation Issues |
| Significant Funding Levels | Administrative Challenges |
| Tax Deductible Contributions | Bonding Required |
| Alternative Asset Options | Higher Plan Fees |
Final thoughts
By now you should understand the pros and cons of using a self-directed defined benefit plan. They can be excellent retirement options. However, they do carry extra administrative tasks.
A defined benefit plan can certainly be self-directed. But before you dive in, make sure you discuss the issue with your CPA and, more importantly, your third-party administrator.
Yes, but be careful. You can invest in all sorts of asset classes like real estate, promissory notes, tax liens, bitcoin, etc. But each asset class has it’s own risk profile so make sure you do your diligence.
These plans are subject to bonding, filing form 5500 (rather than 5500-EZ), and valuation concerns. The compliance is much more challenging compared to a plan that invests solely in qualified assets.
Is a Cash Balance or Defined Benefit Plan Right For You?
The first step is to discuss the process and complexity with your administrator and CPA. Only then can you understand how differently they operate. The good news is that the set up process is rather straightforward.
Would like information and guidance on self-directed Defined Benefit Plans, also banks would set one of these up.
Hi Dennis – We have worked a lot with Solera bank. You can find out more about them here: https://www.solerabank.com/self-directed.php
There are a lot of complexities with the self-directed plans. You should probably schedule a quick call with us just to find out a little more about some of the rules. But they can work great in certain situations.