If you are an active trader of securities for your own account, you may qualify under special IRS rules to file taxes as a business (this is true even if you don’t have clients). As a one-employee business, you are eligible to participate in a one-participant (solo) 401(k) plan. And this, of course, allows you to set some of your earned income aside tax deferred for retirement. But how do you qualify as a “business?” let’s take a look.
For the IRS to consider you in “business” as a trader in securities (hereinafter referred to as a “trader”), you must meet three conditions: (1) Profit must be generated from changes in the price of securities you are trading (not dividends, interest, or capital appreciation); (2) Trade volume must be substantial; and (3) Trading activity must demonstrate continuity and regularity. If your trading activities don’t meet the above criteria, the IRS will simply consider you an investor.
NOTE: As a trader, you will report your business expenses on Form 1040, Schedule C (Schedule A limitations on investment interest expense do not apply to interest paid or incurred in your trading business). Commissions and other costs of buying or selling securities–while not deductible–must be used to calculate gains and losses.
If you meet the IRS conditions as a trader, you should qualify to participate in a solo-401(k) plan. That means that you the business owner can make contributions to the plan as both an employee and an employer. While this may sound complicated, setting up the plan is easy because you can use the same custodian you currently use for trading.
Solo 401(k) plans offer a great deal of flexibility because contributions are made at your own discretion. This gives you the option of maximizing your contributions according to IRS limits (see below), or reducing or suspending them if necessary. (Speaking of flexibility, you can make Roth or Traditional contributions to your solo 401(k) plan.)
Investment options in solo 401(k) plans are virtually limitless. You can invest in the same securities you currently trade such as stocks, bonds, ETFs, commodities, etc. The idea is that you take some of the profits from your trading business and make tax-deferred contributions to the solo 401(k).
To further consolidate and simplify your retirement planning, you can rollover other qualified plans such as a 401(k), 403(b) or a SEP into your solo 401(k) plan (Roth IRAs are not eligible to rollover). You can then implement all your long-term investment strategies within the solo 401(k).
Surprisingly, the IRS does not require you to file an annual report with the agency unless the value of your solo 401(k) plan exceeds $250,000. You may qualify for a tax deduction if you pay the cost of administering the plan (including any annual maintenance fees) out of business funds.
As an employee you can defer 100% of your compensation up to $17,500 ($23,000 if you are age 50 or over) for 2013. As an employer, you can contribute up to 25% in matching compensation as defined by the plan. That makes total allowable contributions for 2013 $51,000 ($56,500 if you’re over 50).
As you can see, for traders who qualify, a solo 401(k) can be an excellent vehicle for helping you enjoy a secure retirement. And, it’s nice to see the IRS actually creating and encouraging the use of such a tax-deferral plan. Visit www.irs.gov to learn more about the solo 401(k) and see if it’s right for you.
= = =
David L. Blain, CFA, is president and chief investment officer of D. L. Blain & Co., a registered investment advisor in New Bern, North Carolina. Reach him here with questions.
