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A Solo 401(k), (also known as a Self Employed 401(k) or Individual 401(k)), is a 401(k) qualified retirement plan for Americans that was designed specifically for employers with no full-time employees other than the business owner(s) and their spouse(s). The general 401(k) plan gives employees an incentive to save for retirement by allowing them to designate funds as 401(k) funds and thus not have to pay taxes on them until the employee reaches retirement age. In this plan, both the employee and his/her employer may make contributions to the plan. The Solo 401(k) is unique because it only covers the business owner(s) and their spouse(s), thus, not subjecting the 401(k) plan to the complex ERISA (Employee Retirement Income Security Act of 1974) rules, which sets minimum standards for employer pension plans with non-owner employees. Self-employed workers who qualify for the Solo 401(k) can receive the same tax benefits as in a general 401(k) plan, but without the employer being subject to the complexities of ERISA.
Prior to 2001, self-employed workers were limited to a profit sharing retirement plan that did not include any employee deferral options in contrast to a multiple employer 401(k) Plan. There existed a retirement platform unique to self-employed workers, the SEP IRA and the Keogh Plan, but it lacked many of the benefits of the typical corporate 401(k) platform, such as employee deferral. Congress remedied this situation in 2001 with the passing of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA). Although EGTRRA was primarily known for its tax reductions, it also amended tax law to allow for self-employed individuals to access a 401(k) style retirement platform. This platform became popularly known as the Solo 401(k).
In order to qualify for a Solo 401(k), an individual must claim some self-employed income. However, he/she does not need to work full-time in a self-employed capacity. A common example of part-time self-employed income is an individual who works for an employer, but also does a little consulting on the side. The consulting income would be considered self-employed income, thereby rendering the individual’s business eligible for adopting a Solo 401(k). A Solo 401(K) Plan can be adopted by any self-employed business, including a sole proprietorship, limited liability company, partnership, C-Corporation, S-Corporation etc.
In addition to being self-employed, the business adopting the Solo 401(k) Plan must also not employ any full-time employees (with the exception of a spouse.) A full-time employee is generally defined as one who works at least 1,000 hours per year for his/her employer.
The two basic types of Solo 401(k) plans are brokerage based and self-directed, also known as a “checkbook control” Solo 401(k). The type of plan is based on the plan documents. The basic plan documents state and control the operations of the plan and the adoption agreement offers the employer the ability to customize the plan based on the options available in the basic plan. In other words, the options available to an adopting employer and its plan participant(s) would be based on the options available in the basic plan document and plan adoption agreement. A plan sponsor, a company offering the plan to the employer, would typically offer either an individual designed Solo 401(k) Plan or a prototype plan.
Brokerage based plan documents usually limit the available investment options and offer market-based assets, such as stocks and mutual funds, while self-directed plan documents generally offer more investment options and often allow for alternative assets, such as real estate and private business, as well as include a loan feature and Roth deferrals. Investors typically choose between the two plans based on their investment goals, asset preference, fee schedules, and desired level of control.
While a brokerage based Solo 401(k) plan and self-directed Solo 401(k) plan would both be considered a qualified retirement plan, the options available under these plans as per the Plan Adoption Agreement generally differ in a number of ways:
The contribution limits for the Solo 401(k) are the same as a standard ERISA 401(k). They are broken down into a profit sharing contribution which comes from the employer, and a salary deferral contribution which comes from the employee. However, due to the fact that in a Solo 401(k) the plan holder is acting both as employer and employee, the actual percentages assume a more meaningful role. If the plan holder is filing as a Sole Proprietor or Single Member LLC (which is true in most cases), then the limit is capped at 20% of the self-employed income plus $18,000 for 2015, an increase of $500 from 2014. Internal Revenue Code Section 401(a)(3) states that the amount of employer contributions is limited to 25 percent of the entity’s income subject to self-employment tax. Schedule C sole-proprietors must do an added calculation starting with earned income to determine their maximum contribution, which, in effect, brings the maximum 25% of compensation limit down to 20% of earned income. A step-by-step worksheet for this calculation can be found in IRS Publication 560.
If the plan holder is 50 years or older, then he/she may contribute an additional $6,000 for 2015, a $500 increase from 2014, on top of the standard contribution. This additional contribution is often referred to as a catch-up contribution. Note this additional catch-up contribution does not apply to the SEP IRA. Calculating one's maximum annual solo 401(k) contribution limitation, including employee deferrals and profit sharing contributions, is based on self-employment income or W-2 income earned by the plan participant and the adopting employer’s established legal entity (sole proprietorship vs. “C” corporation). In other words, in the case of a “C” or “S” corporation, the employee deferral and profit sharing contribution is based off the individual plan participant’s W-2 amount.
In both cases, the IRS has declared an upper limit for total employer and employee contributions to a plan—the IRC Section 415(c) limit—which may not be exceeded. As of 2015, this upper limit is $53,000 for those under 50, an increase of $1000 from 2014, and $59,000 for those 50 and older, an increase of $1500 from 2014. If an individual is eligible to contribute to the 401(k) plans of multiple unrelated employers, employee deferral and profit sharing contributions can be made to each plan but cannot exceed the annual limitation when taking contributions to all plans in the aggregate.
The employee deferral contribution can be made in both pre-tax or after-tax (Roth), so long as the plan documents allow for it. The employer profit sharing contributions must be made in pre-tax form.
Thanks to the American Taxpayer Relief Act of 2012, If your plan documents allows it, you can roll over any vested plan balance, including Solo 401(k) plan employee deferrals and employer profit sharing contributions, as well as earnings, to a designated Roth account, even if these amounts can’t be distributed to you. The purpose behind the relaxation of the in-plan Roth rollover rules is to encourage plan participants to do Roth conversions and thereby increase the amount of current tax revenues collected by the Treasury. If your Solo 401(k) plan documents allows them, you can do an in-plan Roth rollover by:
·Direct rollover by asking the plan trustee to transfer your non-Roth amount to a designated Roth account in the same plan (in-plan Roth rollovers of amounts not normally distributable must be accomplished via a direct rollover), or ·60-day rollover by having the plan distribute an eligible rollover distribution to you from your non-Roth account and then depositing all or part of that distribution to a designated Roth account in the same plan within 60 days.
The in-plan Roth rollover is treated as taxable income (fair market value minus your basis in the distribution) and you must report the Roth rollover in your gross income for the tax year in which you receive it. There is no income tax withholding required on an in-plan Roth direct rollover. However, if you receive a distribution from your plan, the plan must withhold 20% federal income tax on the untaxed amount even if you later roll over the distribution to a designated Roth account within 60 days.
For a sole proprietorship, partnership or an LLC taxed as a sole proprietorship, the deadline for depositing salary deferrals into the Solo 401k is generally the personal tax filing deadline April 15 (or October 15 if an extension was filed).
For a sole proprietorship, partnership or an LLC taxed as a sole proprietorship the deadline to fund the profit sharing contribution is the personal tax filing date of April 15 (or October 15 if an extension was filed).
The Solo 401(k) is an IRS Qualified Retirement Plan which means that it shares the same tax benefits as other QRPs. A qualified retirement plan is a plan that meets requirements of the Internal Revenue Code and as a result, is eligible to receive certain tax benefits. For a Traditional Solo 401(k), the income contributed into the plan is tax deferred. The concept of tax deferral is premised on the notion that all income and gains generated by the pre-tax retirement account investment would generally flow back into the retirement account tax-free. Instead of paying tax on the returns of a self-directed IRA investment, such as real estate, tax is paid only at a later date, leaving the investment to grow unhindered. For example, if an IRA investor invested $100,000 into a Self-Directed IRA LLC in 2012 and the account earns $10,000 in 2012, the investor would not owe tax on that $10,000 in 2012. Instead, the self-directed IRA investor would be required to pay the taxes when he or she withdraws the money from the IRA, which could be many years later. For example purposes, assuming the IRA investor mentioned above is in a 33% federal income tax bracket, she would have had to pay $3,333 in federal income taxes on the $10,000 earned on the IRA in 2012. That would have left $6,667 in the account. At an 8% annual return, those earnings would go on to produce $533.36 in 2013. However, because IRAs are tax deferred, the self-directed IRA investor is able to earn a return on the full $10,000 rather than the $533.36 she would have had if she had to pay taxes that year. At an 8% annual return, she'd earn $800 in 2013. The beauty of tax deferral is that the deferral compounds each year. Tax deferred investments though a self-directed IRA LLC generally help investors generate higher returns. That's because the money that would normally be used for tax payments is instead allowed to remain in the account and earn a return.
Tax responsibility doesn't start until retirement age as the plan holder begins to take out Required Minimum Distributions (RMDs). The tax bracket is determined at the time that the distributions are taken. For a Roth Solo 401(k), the funds go in as post-tax dollars and thus are no longer subject to taxation, assuming the distribution would be treated as a qualified distribution. For a distribution to be qualified, it must occur at least five years after the Roth Solo 401(k) Plan participant established and funded his/her first Roth 401(k) plan account, and the distribution must occur under at least one of the following conditions:
If a plan holder is using his/her Solo 401(k) funds to invest in an active business held through a passthrough entity, such as a limited liabilited company or partnership, then there is the possibility of Unrelated Business Income Tax (UBIT or UBTI). This is a tax that is levied on tax exempt entities, such as a charity, IRA, or 401(k) Plan, that have invested in an active trade or business unrelated to its exempt purpose. The net profits allocated to the tax-exempt entity from the active trade or business held through a passthrough entity are subject to UBIT on a yearly basis from the business are subject to UBIT on a yearly basis. The UBTI is reported on the IRS Form 990-T. Most investments entered into by retirement plans, however, are not considered active businesses, and therefore are not subject to UBIT.
The tax forms that apply to a Solo 401(k) can vary according to the assets and size of the plan. Here is a listing of the most common: