Passive vs active income. It’s a topic we cover often with new clients hoping to set up a Solo 401k. Only active business income qualifies you to have a Solo 401k. So, how do you know if your business generates passive vs active income? As a Solo 401k owner, you have to earn active income but you want your retirement account to grow from passive income.
You may have your own definitions for passive and active income. However, in the context of your Solo 401k, what counts is the IRS definition. That definition is in IRS Publication 925 (for 2019 tax returns). Also, refer to About Publication 925 where you’ll find revisions and updates.
Why Passive vs. Active Income is Important to A Solo 401k
Some Solo 401k owners believe contributions to the retirement plan are based on total income (earned income plus passive income). That is not correct. Solo 401k contributions only come from earned income subject to FICA and Medicare taxes.
Your Solo 401k receives two types of contributions from your self-employed business:
- Employee (salary deferral) Contributions
- Employer (profit sharing) Contributions
You are both the business owner and the employee of your business. As an employee, your salary deferral contributions come from the active income that you receive. The employee contribution may be up to 100% of your net compensation.
Defining Earned Income
“Earned income” is another term for active income. Simply put, the IRS states there are two ways to generate earned income:
- You work for someone who pays you; or
- You own or run a business or farm
Examples of earned income are wages, salaries, tips, and other taxable employee compensation. Earned income also includes net profit from self-employment.
Earned income also includes union strike benefits and disability retirement benefits received before minimum retirement age. These seldom apply to Solo 401k owners. Social security and unemployment benefits are not earned income.
Is Real Estate Rental Income Passive or Active?
Rental income is NOT earned income unless you generate it from self-employment. Most rental income is passive. Passive income cannot be a tax-deferred contribution to your Solo 401k. To have rental income qualify as earned income, you typically need to be considered a “real estate professional”. To be a real estate professional, you must “provide more than one-half of his or her total personal services in real property trades or businesses in which he or she materially participates and perform more than 750 hours of services during the tax year in real property trades or businesses”. (Source)
Certain real estate activities allow you to operate as a business that generates active income. That active income can be contributed to your Solo 401k. Perhaps you’re a property manager that manages property NOT OWNED by your Solo 401k. Or maybe you’re a real estate agent earning commissions. Those commissions are active income that you may contribute to your Solo 401k.
However, remember you cannot earn commissions from selling or buying property involved with your Solo 401k. Your business might generate active income from rehabbing and selling houses (again, these houses cannot be involved with your Solo 401k). The bottom line is that your active income has to come from sources that are completely separate from your Solo 401k. See Disqualified Persons and Prohibited Transactions.
Passive Income Belongs in a Retirement Plan
This is the type of income that you want your Solo 401k to earn. Passive income requires little or no effort to earn and maintain. This is income that you are not directly working for. Real estate investing can generate passive income that goes directly into your Solo 401k as tax-deferred profits. This passive income must come from assets owned by the Solo 401k.
This is where passive vs active income generation makes a big difference. As the trustee of your Solo 401k, you decide what rental properties the Solo 401k invests in. However, and very importantly, you cannot actively work on the properties. The IRS considers that self-dealing.
Your Solo 401k is Not a Business – It’s a Retirement Plan
Buying rental real estate with your retirement plan generates passive (tax-deferred income). Working on your business generates active income, and you pay taxes on those earnings.
Perhaps you invest in real estate in your Solo 401k, and flip properties in your real estate business. Those two activities are very different from one another. One generates passive income, the other generates active income. Draw a very clear line between your business and your retirement plan. Your business generates income from your hands-on work and involvement.
On the other hand, the Solo 401k only generates income from investments, including dividends, rental property income, or earnings from which you are not materially involved.
Your business should earn (and pay taxes on) active income. The IRS only allows you to contribute active income to your Solo 401k. That is your salary deferral and profit sharing contributions.
Once the money is in your Solo 401k, it is no longer part of your business. It is now part of your business’ retirement plan. This can seem more complicated if the business you own is earning money from real estate work and your Solo 401k is earning money from real estate investments.
The bottom line is that your business needs to generate active earned income. You can fund your Solo 401k through contributions generated from earned active income. These contributions reduce the amount of taxes that you pay on active income. However, you should still expect to pay self-employment tax as a result of owning and operating a business.
Earned Income and Your Solo 401k
As you can see, the difference between passive vs active income matters when it comes to your business and your retirement plan. When it comes to money earned by your Solo 401k, you want passive income. It’s common to generate passive income from real estate investments. That is, so long as you don’t personally work on properties. Therefore, don’t do repairs, maintenance, rehabs, etc. Your Solo 401k generates passive income from residential rentals, lease options, commercial leases, triple net leases, stocks and bonds, and other passive income sources.
Keep active income in your business, and passive income in your retirement plan. Once you master those two income sources, your retirement will be set for life!
Nabers Team, another great article! However, I have a question that perhaps you could assist in answering.
I use my Solo401 to build new homes. My involvement is limited to picking a location and general contractor and of course, funding the deal. Do you have any articles that perhaps would clarify if I’m doing this correctly? I.e., not going against any IRS rules.
Hi Todd, so long as your Solo 401k is just “the money guy” this should be OK. Of course, we’d strongly recommend you check with legal counsel and/or your tax advisor to ensure that the Solo 401k footing the bill for building properties isn’t going to trigger Unrelated Business Income Tax (UBIT).