Solo 401(k) Plan Distribution Rules
A Solo 401(k) plan is a great retirement plan for accumulating retirement wealth through high contributions and alternative asset investment opportunities. However, there are times that one needs to access their Solo 401(k) plan funds either voluntarily or as required by law.
In the case of an IRA, the IRA owner may take distributions from his or her IRA at any time. The determination of whether the distribution is taxed depends on the type of IRA (i.e., traditional or Roth), the age of the IRA owner, and in the case of a Roth IRA, the duration of time the account has been established. However, when it comes to taking funds out of a 401(k) plan, there are certain rules and requirements that must be satisfied before a distribution can be taken.
It may seem unfair to some that one would need to satisfy certain rules before gaining access to ones Solo 401(k) plan funds, but that is the way the rules work. When it comes to determining what funds in your Solo 401(k) plan you will have access to, the first thing to do it to look at the Solo 401(k) Basic Plan Document or speak with your plan administrator. That being said, the following is a general overview of the distribution rules most commonly found in standardized Solo 401(k) plan documents in the marketplace today.
Before we get into the taxable ways one can to take funds out of your 401(k) plan, the Solo 401(k) loan feature, which is an option in many Solo 401(k) plan, is essentially the only way one can get tax-free and penalty free use of funds in a Solo 401(k) Plan.
Solo 401(k) Plan Loan Option
If your Solo 401(k) plan offers the Solo 401(k) loan option, a plan participant has the ability to borrow the lesser of $50,000 or 50% of their plan account value. The personal loan can be used for any purpose. The Solo 401(k) plan loan must be paid back over a five-year period, at least quarterly, at a minimum interest rate of Prime as per the Wall Street Journal, which as of 12/21/15 is 3.50%.
The Solo 401(k) Plan loan feature would allow a plan participant to use plan funds for any purpose without having to worry about the plan distribution rules.
In the cases where the Solo 401(k) plan loan feature is not a viable option and the plan participant is need of plan funds, there are several other options for accessing the funds.
In the case of retirement funds that have been rolled into the plan from another retirement account, such as an IRA or 401(k) plan, those funds can generally be rolled out of the plan at any time without the need for any triggering event. A rollover is not a contribution made to the plan by the plan participant or employer, but retirement funds contributed to n IRA or another 401(k) plan that are now being transferred into the plan. Most Solo 401(k) plan documents include a provision that allows rollover funds to be rolled out of the plan and into another retirement account without the need to satisfy any age requirements or plan service rules.
Elective employee deferrals are amounts contributed to a plan by the employer at the employee's election and which, except to the extent they are designated Roth contributions, are excludable from the employee's gross income. For 2016, up to $18,000 per year can be contributed by the participant through employee elective deferrals. An additional $6,000 can be contributed for persons over age 50. The contributions can be up to 100% of the participant’s self-employment compensation.
In the case of employee deferrals, most Solo 401(k) plan documents do not allow a plan participant to access employee deferrals unless a plan triggering event has occurred or they can satisfy a hardship distribution criteria.
Plan Triggering Event
In general, distributions from a Solo 401(k) cannot be made until one of the following occurs:
· The employee reaches retirement age as defined under the plan, which is typically the age of 591/2.
· The employee becomes disabled.
· The employee dies, at which time the beneficiary is eligible for distributions.
· The employee separates from service.
· The plan is terminated and is not replaced by another defined contribution plan.
Therefore, if a plan participant is under the age of 591/2 and continues to be employed by the adopting employer and the plan is not being terminated, other than in the case of a hardship, the plan participant would not be able to access his or her employee deferrals for purposes of taking a distribution from the plan.
The determination of whether your Solo 401(k) plan will allow for hardship distributions is based on the plan documents. Satisfying the hardship distribution rules could allow you to access your funds and would allow you to eliminate paying the 10% early distribution penalty, but it will not allow you to circumvent paying tax on the hardship distribution amount, is applicable.
If a Solo 401(k) plan provides for hardship distributions, it must provide the specific criteria used to make the determination of hardship. Thus, for example, a plan may provide that a distribution can be made only for medical or funeral expenses, but not for the purchase of a principal residence or for payment of tuition and education expenses. In determining the existence of a need and of the amount necessary to meet the need, the plan must specify and apply nondiscriminatory and objective standards. Below are some of the most common criteria found in standard Solo 401(k) plan documents for taking a hardship distribution:
· Medical expenses for you, your spouse or your dependents or expenses that are necessary for these persons to obtain medical care.
· Purchase of your principal residence (excluding mortgage payments). Amount is capped at $10,000.
· Payment of tuition and related educational fees, and room and board expenses for the next 12 months of post-secondary education for you, your spouse or your dependents.
· The need to prevent the eviction from, or mortgage foreclosure of, your principal residence.
· Payment for burial or funeral expenses for your deceased parent, spouse, children or dependents.
· Expenses for the repair of damage to your principal residence that would qualify for the casualty deduction under Code Section 165.
In summary, in the case of employee deferrals, if a plan participant is not able to satisfy any of the plan triggering events or any of the hardship distribution requirements contained in the Solo plan, the plan participant is generally not able to access any employee deferral contributions made to the plan.
Employer Profit Sharing Contributions
In general, most Solo 401(k) plan documents allow the employer to make employer profit sharing contributions, which are based off a percentage of the plan participant’s income amount. For 2016, the employer may make an additional contribution to the plan participant in an amount up to 25% of the participant’s self-employment compensation (20% in the case of a Sole Proprietor or a Schedule C Tax Payer).
Unlike employee deferrals, most Solo 401(k) plan documents allow employer profit sharing contributions to be accessed after a certain amount of time, also known as a vesting period. Most plan documents allow a plan participant to access all employer profits haring contributions after being in the plan for over five years (five-year vesting period). In addition, some Solo 401(k) plan documents allow a plan participant to access some of the employer profit sharing contributions after being in the plan for two years (two-year vesting schedule). Any employer profit sharing contributions taken as a distribution would be subject to tax and penalty, if applicable.
In general, an after-tax contribution is a contribution made to a Solo 401(k) plan or any other retirement account after taxes has been deducted from an individual's taxable income. The Solo 401(k) plan documents will determine whether after-tax contributions are permitted to be made to the plan. In the case where after-tax contributions can be made to the plan, most Solo 401(k) plan documents do not impose any rules or restrictions on accessing the after-tax funds for rollover or distribution. In other words, unlike employee deferral and employer profit sharing contributions, no plan-triggering event, hardship criteria, or vesting schedule must be satisfied. The after-tax funds are available at anytime for rollover or distribution. This has contributed to the growing popularity of using after-tax contributions as a means of maximizing ones annual Solo 401(k) contributions as well providing greater access to ones retirement funds when necessary.
For more information on the distribution rules for a Solo 401(k) plan, please contact a retirement tax specialist at 800-472-0646.