Solo 401(k) FAQ
What is a Solo 401(k) Plan?
If you’re self-employed with a Solo 401(k), it may surprise you that a frequently asked question regarding this retirement plan is: what is a Solo 401(k)?
A Solo 401(k) plan is not a new type of retirement plan. Essentially, it’s a traditional 401(k) plan that covers only one employee. In a nutshell, you can establish a Solo 401(k) plan if you’re self-employed or have a small business with no full-time employees other than yourself or a spouse.
As the name implies, the Solo 401(k) plan is an IRS approved 401(k) plan for a self-employed individual or the sole owner-employee of a corporation. It works best when there are no other employees or a very small number of employees.
What are the eligibility requirements for a Solo 401(k) Plan?
One part of the Solo 401(k) rules is the eligibility requirement. A Solo 401(k) plan is best for businesses that either do not employ any employees or employs certain employees that may be excluded from coverage. For example, employees who don’t work full-time.
In order to be eligible to benefit from the Solo 401(k) plan, you must meet two eligibility requirements according to the Solo 401(k) rules:
- The presence of self employment activity.
- The absence of full-time employees.
You (the business owner) and your spouse are technically “owner-employees” rather than “employees”.
The following types of employees may be generally excluded from coverage:
- Employees under 21 years of age
- Employees that work less than a 1000 hours annually (full-time)
- Union employees
- Nonresident alien employees
What can I invest in using my Solo 401(k) Plan?
A Solo 401(k) lets you use your retirement funds to make virtually any type of investment. You can do this on your own, without custodian consent.
The IRS only describes the type of investments you cannot make, which are very few. The following are some types of investments you can make with your Solo 401(k) Plan:
- Residential or commercial real estate
- Raw land
- Foreclosure property
- Mortgage pools
- Private loans
- Tax liens
- Private businesses
- Limited Liability Companies
- Limited Liability Partnerships
- Private placements
- Stocks, Bonds, Mutual Funds
- Most currencies
Who receives the most benefits from a Solo 401(k) Plan?
The Solo 401(k) is unique because it was designed explicitly for small, owner only business. It’s the most tax efficient and cost effective plan that offers all the benefits of a Self-Directed IRA plan.
Additionally, it includes benefits such as high contribution limits (up to $62,000) and a $50,000 loan feature.
There are many features of the Solo 401(k) plan that make it so appealing among self employed business owners.
Do I need to pay a custodian if I have a Solo 401(k) Plan?
Another benefit of the Solo 401(k) is that you do NOT have to pay a custodian. In fact, this may be the most significant cost benefit of the Solo 401(k) Plan.
The retirement plan does not require you to hire a bank or trust company to serve as trustee. With IRA Financial Group’s Solo 401(k) plan, you can open the plan account at most local banks or financial institutions, such as Wells Fargo or Fidelity.
What is a Solo 401(k) Plan Loan?
To further explain the Solo 401(k) loan, participants are allowed to use the accumulated balance of the Solo 401(k) as collateral for the loan. You can borrow up to $50,000 or 50% of the account value – whichever is less.
However, it’s important to note that you must repay the loan over an amortization schedule of five years or less. Payment frequencies must be no greater than quarterly. The interest rate must be set at a reasonable rate of interest, generally interpreted as prime rate as per the Wall Street Journal.
As of 1/1/19 prime rate is 5.50%, which means participant loans may be set at a very reasonable Interest rate. The Interest rate is fixed based on the prime rate at the time of the loan application.
How is the Solo 401(k) Plan Loan done?
As long as the plan documents allow for it and the proper loan documents are prepared and executed, you can make a participant loan for any reason. The Solo 401(k) loan is tax free and penalty free as long as you pay the loan on time.
The IRA Financial Group Solo 401(k) Plan documents will allow you to use a loan from your Solo 401(k) for any investment purposes, including real estate, funding your business or a new business, tax liens, private placements, etc. You can even use it to pay off debt.
Is the Solo 401(k) Plan Loan Legal?
Yes, the loan is legal.
Internal Revenue Code Section 72(p) and the 2001 EGGTRA rules allow a Solo 401(k) Plan participant to borrow money from the plan tax-free and without penalty. IRA Financial Group’s in-house retirement tax professionals will assist you in completing the Solo 401(k) Plan documents in a timely manner once you adopt your Solo 401(k) Plan.
What are some benefits of using the Solo 401(k) loan feature?
The Solo 401(k) Plan loan is perfect if seek immediate funds for your business or start-up. Other useful ways of using the participant loan feature is to:
- Lend the funds to a third-party who will pay a higher interest rate
- Invest in a real estate project that offers a higher rate of return than the low interest rate you must pay
- Consolidate debt
- Pay for college expenses
- Pay for unexpected emergencies
- Invest in a new franchise or business
- Make any alternative investment that will generate a higher rate of return than the low Interest rate imposed on you, such as tax liens, private placements, or mortgage pools
- Invest in a transaction that would otherwise be a Prohibited Transaction under Internal Revenue Code Section 4975
Do Solo 401(k) rules restrict my spouse from using the loan feature?
One of the main advantages of the Solo 401(k) Plan is that it allows participants to borrow up to $50,000 or 50% of their account value (whichever is less) for any purpose.
You and your spouse can borrow up to $50,000 ($100,000 total).
What are the contribution limits for a Solo 401(k) Plan?
A Solo 401(k) participant can contribute to the plan as an employee and as employer.
- Employee Elective Deferrals: For 2019, you can contribute up to $19,000 per year through employee elective deferrals. Contribute an additional $6,000 if you’re over age 50. These contributions can be up to 100% of your self employment compensation.
- Employer Profit Sharing Contributions: Through the role of employer, you can make an additional contribution in an amount up to 25% of the participant’s self employment compensation.
- Total Limit: The sum of both contributions can be a maximum of $56,000 per year (for 2019) or $62,000 for persons over age 50. If the business owner’s spouse elects to participate in the Solo 401(k) and earns compensation from the business, the spouse can make separate and equal contributions increasing the couples’ annual total contribution to $112,000 for 2019 or $124,000 if both spouses over age 50.
What is a qualified plan?
A qualified plan is a type of retirement savings plan that an employer establishes for its employees that conforms to the requirements of Section 401 of the Internal Revenue Code.
It is called a “qualified plan” because it meets all the requirements of Section 401. Thus, it qualifies for special tax rules, the most significant of which is that contributions the employer makes to the plan on behalf of its employees are tax deductible.
The advantages to the employee working for an employer with a qualified plan are not only the opportunity to accumulate a retirement nest egg, but also to postpone paying income tax on the money he/she contributes to the plan.
What is a 401(k) plan?
A 401(k) plan is a special type of profit sharing plan. A traditional 401(k) plan allows you to direct some of your compensation into the plan and you do not have to pay income taxes on the portion of your salary you direct into the plan until you withdraw the funds.
What is a Roth 401(k) Plan?
Employers can also establish a special type of 401(k) plan: the Roth 401(k). This plan is similar to a traditional 401(k) plan in that it allows employees to defer salary into the plan. The difference relates to the tax treatment.
Contributions to traditional 401(k) plans are tax deductible, but contributions to Roth 401(k) plans are not tax deductible. Whereas, the tax benefits for a Roth 401(k) come when you take distributions.
Distributions are tax free as long as meet certain requirements. For example, the Roth account must be open at least five years and you must be over the age of 59 1/2 .
The IRA Financial Group’s Solo 401(k) Plan allows for Roth type contributions.
What type of administrative costs and maintenance is necessary to maintain a Solo 401(k) Plan?
The solo 401(k) plan is easy to operate. There is generally no annual filing requirement unless your Solo 401(k) Plan exceeds $250,000 in assets. In such a case, you will need to file a short information return with the IRS (Form 5500-EZ).
Beyond this reporting requirement, you must maintain basic reporting requirements. This essentially means you must keep all records, receipts, contracts relating to the Solo 401(k) and its investments on file.
As a beneficiary of a Solo 401(k) Plan, what are my options for inherited plans?
If you are a beneficiary (rather than the owner) of a qualified plan and receive a distribution as a result of the owner’s death, you have the following options:
1. Pay ordinary income tax
If plan assets are distributed to you, then you will have to report the distribution as income on your tax return. However, if you receive a distribution from a plan you inherit, you will not have to pay an early distribution tax, even if you are younger than 59 1/2. The penalty is waived for inherited plans.
2. Roll over the distribution
If you inherit a plan and you were the spouse of the original owner, you can roll over the distribution into a traditional or Roth IRA. However, if you inherit a retirement plan, such as a 401(k) Plan, and you were not the spouse of the original owner, then you may roll over the plan assets into a traditional IRA if you follow certain rules.
For example, you may not roll over the assets into a plan or IRA that is in your own name. You must establish a new IRA that is titled in the name of the deceased with you as the designated beneficiary.
3. Convert to a Roth IRA
A spouse that inherits a retirement plan is provided virtually all of the distribution options offered to the deceased plan participant. A Roth IRA conversion is subject to tax, but not the 10% early distribution penalty.
How do the withholding tax rules work for Solo 401(k) Plan distributions?
In 1993, Congress passed a mandatory withholding law. The law requires your plan administrator to keep 20% of all qualified plan distributions to pay federal income tax before distributing the remainder to you. There are, however, some exceptions to the mandatory withholding rule.
For example, the amounts that are transferred directly from the trustee of your retirement plan to a trustee of another plan or a custodian of an IRA are not subject to withholding (direct rollover).
Note: Plan administrators are required to notify you of the direct rollover option at least 30 days before the distribution is to take place.
Can I make contributions to both a SEP and a Solo 401(k) Plan?
It is good practice to not have a SEP IRA and Solo 401(k) plan open at the same time. In fact, according to IRS Form 5305, any employer that establishes a SEP IRA using the form cannot have both a SEP IRA and Solo 401(k) Plan opened at the same time.
The main reason is that both plans have employer profit sharing options. However, if a bank or IRA custodian establishes the SEP IRA by using an individually drafted document other than IRS Form 5305, then an employer can have a SEP IRA and Solo 401(k) plan at the same time. However, this is quite uncommon.
What commonly occurs is that an employer will have a SEP IRA and make contributions to it and then open a Solo 401(k) plan. Then the employer will roll the SEP IRA contributions tax-free into the plan. The employer will then close the SEP IRA and only keep the Solo 401(k) plan.
Is a Solo 401(k) Plan subject to the same UBTI rules as a Self-Directed IRA LLC?
Yes and No. The type of income that generally could subject a Solo 401(k) to UBTI or UBIT is income generated from the following sources:
- Income from the operations of an active trade or business – i.e. a restaurant, gas station, store, etc.
- Business income generated via a passthrough entity, such as an LLC or partnership
- Using margin on a stock purchase
Nonrecourse Leverage to Purchase Real Estate
Unlike a Self-Directed IRA LLC, in the case of a Solo 401(k) Plan, UBTI does not apply to unrelated debt-financed income (UDFI) when using nonrecourse leverage to purchase real estate.
The UDFI rules apply when a 401(k) Plan uses leverage to acquire property such as real estate. Pursuant to Internal Revenue Code Section 514(c)(9), a 401(k) Qualified Plan is not subject to the UDFI rules and, thus, the UBTI tax if nonrecourse leverage is used to acquire property such as real estate.
With the UBTI tax rates at approximately 37% for 2019, the Solo 401(k) Plan offers real estate investors looking to use nonrecourse leverage in a transaction with a tax efficient solution.
Am I subject to UBTI Tax on Unrelated Debt Financed Income in a Solo 401(k) Plan?
No. Unlike a Self Directed IRA LLC, when a Solo 401(k) Plan uses nonrecourse leverage to purchase real estate that is leveraged, it is exempt from paying any Unrelated Business Taxable Income (UBTI) tax on the income or gain generated.
Why does the UBTI Exemption for Using Leverage in a Solo 401(k) Apply to 401(k) Plans and Not IRAs?
When Internal Revenue Code Section 514(c)(9) was enacted in 1980, it applied only to qualified pension, profit sharing, and stock bonus plans. However, its scope was broadened in 1984 to include schools, colleges, and universities.
The provision brings the history of Internal Revenue Code Section 514 full circle by exempting some organizations, such as 401(k) Qualified Plan, from tax on income from the very sort of leveraged real estate deals that provoked the enactment of the predecessor of Internal Revenue Code Section 514 in 1950.
As per the legislative history, the only reason given in the committee reports for the exemption is that some people wanted it: “Trustees of these plans are desirous of investing in real estate for diversification and to offset inflation. Debt-financing is common in real estate investments.”
Using a Solo 401(k) Plan, what type of transactions may trigger the UBTI tax?
In general, most passive investments that your Solo 401(k) Plan might invest in are exempt from UBTI. Some examples of exempt type of income include: interest from loans, dividends, annuities, royalties, most rentals from real estate, and gains/losses from the sale of real estate.
The type of income that generally could subject a Self Directed Solo 401(k) plan to UBTI or UBIT is income generated from the following sources:
- Income from the operations of an active trade or business – i.e. a restaurant, gas station, store, etc.
- Business income generated via a passthrough entity, such as an LLC or partnership
- Using margin on a stock purchase
What are some of the factors the IRS or the Courts may consider when determining whether a real estate transaction may be subject to UBTI?
In general, the determination of whether a transaction or series of transaction involving a solo 401(k) plan will trigger the unrelated business taxable income (UBTI) tax is based off the facts and circumstances. The maximum tax rate for UBTI is 37% so it is important to have a good handle on whether the tax could be triggered. In general, the following the IRS and the courts will look at the following factors to determine whether the retirement account transaction triggered the UBTI tax:
- Frequency of transactions
- Level of continuity
- Level of improvement
- The proximity of sale to purchase
- Purpose for which the asset was acquired
- Personal activities of taxpayer
What is the UBTI tax rate?
Internal Revenue Code Section 511 taxes “unrelated business taxable income” (UBTI) at the rates applicable to corporations or trusts, depending on the organization’s legal characteristics. Generally, UBTI is gross income from an organization’s unrelated trades or businesses, less deductions for business expenses, losses, depreciation, and similar items directly connected therewith. A Solo 401(k) Plan subject to UBTI is taxed at the trust tax rate because an IRA is considered a trust. For 2019, a Solo 401(k) Plan subject to UBTI is taxed at the following rates:
- $0 – $2,550 = 10% of taxable income
- $2,551 – $9,150 = $255 + 24% of the amount over $2,550
- $9,151 – $12,500 = $1,839 + 35% of the amount over $9,150
- $12,501 + = $3,011.50 + 37% of the amount over $12,500
What are the tax filing requirements for UBTI?
In computing UBTI, a specific deduction of $1,000 is permitted. If a Solo 401(k) Plan has gross UBTI of $1,000 or more during its fiscal year, it must file a completed IRS Form 990-T to report such income and pay any tax due. The Form 990-T is due at the same time as the Form 990; however, if the Solo 401(k) Plan expects its annual UBIT (after certain adjustments) to be $500 or more, then it must make estimated tax payments throughout the year. The Form 990-T is not subject to public disclosure like the Form 990.
Are Solo 401(k) Plans protected from creditors in a bankruptcy proceeding?
Yes. Corporate retirement plans have long been safe from creditors, thanks to the Employee Retirement Income Security Act of 1974, commonly known as ERISA.
Do I need to fund the Solo 401(k) with an existing IRA or 401(k)?
No. You are not required to fund a new Solo 401(k) Plan with an existing IRA or 401(k). You can begin contributing to your new Solo 401(k) Plan once it is established.
How long does it typically take to set-up a Solo 401(k) Plan?
It generally takes one or two days to set-up the Solo 401(k) Plan.
Does the IRA Financial Group’s Solo 401(k) Plan allow for Roth Contributions?
Yes. IRA Financial Group’s Solo 401(k) Plan allows participants to elect to treat contributions under the plan that would otherwise be elective deferrals as designated Roth contributions.
Are the contribution rules for a Roth 401(k) the same as a Roth IRA?
The Roth subaccount of the Solo 401(k) Plan is a bit of a hybrid. Although it is technically a type of 401(k) plan, it has some of the features of a Roth IRA. Only after-tax salary deferral contributions may be deposited in the Roth 401(k) subaccount. No employer contributions and no pretax employee contributions are permitted. Therefore the entire account will contain only after-tax contributions from your salary plus pretax earnings on those contributions. Because the Roth 401(k) is actually just part of a regular 401(k) plan, most of the rules that apply to a regular 401(k) plan also apply to a Roth 401(k) plan, including the contribution limits.
Can a Roth 401(k) Plan exist on its own?
No. A Roth 401(k) Plan is simply an option that can be added to a traditional 401(k) Plan. A Roth 401(k) Plan cannot exist on its own.
When are Roth 401(k) distributions taxable?
Generally, distributions from a designated Roth account are excluded from gross income if they are made after the plan participant reaches the age of 59 1/2 and has opened and funded the Roth 401(k) account for at least 5 years. In addition, distributions made to the plan participant’s beneficiary or estate after the employee’s death is also not taxable.
Can I convert a 401(k) Plan to a Roth 401(k) Plan?
Yes. The Small Business Jobs Act of 2010, signed by President Obama contained a little-known provision, which went to affect on Sept. 27, 2010, allowing for the conversion of a traditional 401(k) or 403(b) account to a Roth in the same plan if the plan documents includes this option. IRA Financial Group’s Self-Directed Solo 401(k) plan documents allows for after-tax contributions and Roth conversion options.
Can I rollover the Roth 401(k) Plan to a Roth IRA?
Yes. You are permitted to roll over your Roth 401(k) plan assets into a Roth IRA without tax or penalty. However, you must have a plan triggering event to move funds out of a 401(k) plan. In general, you need a triggering event to roll funds out of a 401k plan, which typically consists of one of the following: (i) you are over the age of 59 1/2, (ii) you leave your job, or (iii) the company terminates the plan. If funds are rolled directly from a 401(k) plan to an IRA there is no tax or penalty.
Can I rollover a Roth IRA to a Roth 401(k) Plan?
No. Although you are permitted to roll over the assets of a Roth 401(k) plan to a Roth IRA, you may not do the reverse.
How are distributions from Roth 401(k) Plan taxed?
All distributions from Roth 401(k) plans are either qualified distributions or nonqualified distributions. If the distribution is a qualified distribution, the early distribution tax does not apply. The early distribution tax applies only to those distributions that are subject to income tax. Because all qualified distributions from Roth 401(k) Plans are tax free, they are also exempt from the early distribution tax as well. A “qualified distribution” from a Roth IRA is excluded from gross income. To be qualified, a distribution must satisfy both of the following requirements: (1) It must not occur before the fifth taxable year following the year for which a Roth IRA contribution was first made by the taxpayer or the taxpayer’s spouse and (2) It must be made after the account owner reaches age 59 1/2 or becomes disabled, be made to the owner’s beneficiary or estate after the owner’s death, or be a “qualified special purpose distribution.”
Am I required to take Distributions from my Roth 401(k) during my lifetime?
The required distribution rules that force you to begin taking money out of your retirement plans and Traditional IRAs during your lifetime also apply to Roth 401(k) Plans. The required distribution rules also force your beneficiaries to take distributions from the account after your death. Note: the rules for a Roth 401(k) Plan are different from those for a Roth IRA. If you have a Roth 401(k) plan, you must begin taking distributions from the account when you reach age 70 and 1/2, or after you retire, if that is later.
How should a Solo 401(k) Plan trustee administer a 401(k) Plan with Roth contributions?
A trustee of a Solo 401(k) Plan with a qualified Roth contribution program should establish separate accounts including only designated Roth contributions and “earnings properly allocable to the contributions,” and the plan administrator must maintain separate records for these accounts.
I have a defined benefit plan that I max out, can I also adopt a solo 401(k) plan for my business?
Yes – since a defined benefit plan includes only employer contributions, you can establish a Solo 401(k) Plan and make employee deferral contributions to the plan even if you have maxed out your DB contributions. With a Solo 401(k) Plan you will be able to supplement your defined benefit plan contributions and make employee deferral contributions for 2019 equal to $19,000 or $25,000 if you are over the age of 50. The deferrals can me made in pre-tax or after-tax (Roth).
Is a Solo 401(k) Plan subject to the ERISA rules?
The ERISA rules and regulations do not apply to a Solo 401(k) Plan since there are no common law employees to protect since the only employee(s) is the business owner(s) and spouse.
Is it really legal to borrow money from my Solo 401(k) Plan?
The IRS and the Internal Revenue Code permits 401(k) plan participants to borrow money from their qualified retirement plan as long as the Plan documents allow for it. Most Plan documents do allow for it as it is generally an option in the Adoption Agreement, which is the documents that adopts the Plan for the employer. The loan amount cannot exceed the greater of $10,000 (if your balance is under $20,000) or 50% of the plan participant’s vested account balance.
I have an S Corporation and wanted to adopt a Solo 401(k) Plan – can I do this? I know there are some S Corporation restrictions regarding retirement accounts and ownership.
A Solo 401(k) Plan can be adopted by any business type, including an S Corporation.
If I am self-employed, is there any reason I would not want to adopt a Solo 401(k) Plan vs. a Self-Directed IRA LLC?
If you are self-employed or a small business owner with no full-time employees other than the owners, the Solo 401(k) Plan offers the same benefits of a Self-Directed IRA LLC plus many more tax and retirement advantages.
I work full-time with a large employer and have a large 401(k) Plan that I want to rollover into a Self-Directed IRA, how do I know whether I can access my 401(k) plan funds from my current employer’s plan?
In general, a 401(k) or Solo 401(k) Plan participant may take distributions following certain triggering events. Generally, the plan documents dictate when one can take a distribution from it. Triggering events are:
- Severance or termination of employment,
- Attainment of age 59 1/2,
- Attainment of qualified reservist status,
- Plan termination
In the event of a triggering event, the qualified 401(k) plan participant would have the opportunity to roll over the funds to an IRA, Self-Directed IRA with checkbook control, or another 401(k) or Solo 401(k) Plan tax-free.