For any of you who have read any of my posts or watched any of my videos, you know that I have a bias toward self-directed 401K plans over IRA plans for many reasons. Count this as one other reason why I favor the 401k . . . but that is not why I am writing it. You see, every year, people contact me and ask they account for contributions made to either their IRA or 401K. The differences are subtle (but dramatic) between the two plans as they are two totally different plans.
With regard to an IRA, the IRA must be “held” by a custodian that will allow self-direction into non-traditional assets. Part of that custodian’s responsibility is filing the fair market value (FMV) of the IRA to the IRS each year. This done through an IRS Form 5498 and it reports your account balance and any contributions you made to your account during the year. Please note that you will not need to do anything with the 5498 as your custodian will report that information to the IRS on your behalf.
However, here is where, sometimes, there is a disconnect with what the account holder believes they need to do. Let’s say, for example, that an individual set up his self-directed IRA utilizing an LLC component so that they can control their IRA “checkbook.” Let’s also say the individual wanted to make a $5,000 contribution to his IRA during the year. Some individuals ask if they can make their contribution directly to their LLC as they will be using the funds from the LLC for investing purposes. The answer is simply and emphatically:
You see, the LLC is not the IRA. It is merely an asset that is owned by the IRA. That being said, the LLC (as it is not the IRA) cannot accept contributions. Simply stated, the IRA owner wishing to make a contribution must make the contribution into the IRA (held by its custodian) and then, if desired, request that those funds be transferred back out to the LLC.
In contrast to the requirements of the IRA, an individual who holds a 401K (as Trustee) will make contributions into their 401K master account and, most likely (unless making Roth contributions to the 401K), account for these contributions as a “pre-tax” contribution to the 401K plan on their annual 1040 tax form. In this case, while the contribution must still be made into the master account prior to possibly moving the funds back to an LLC account for investment purposes, the transaction is much simpler as the Trustee is the same individual who has the 401K plan. There is no need for separate reporting from a third party entity. Further, while the IRA must have its annual value reported each year, the fair market value of the 401K does not need to be provided to the IRS until assets of the plan reach $250,000. This information is based on 2011 requirements.
Obviously, whether one has an IRA or 401K (self-directed or not), you should always review any transactions you make with either account with your tax or accounting professional. This post was intended to simply explain the differences between reporting a contribution to an IRA vs. a 401K.