I’m routinely asked questions about what taxes and rules apply when a distribution occurs from a retirement account. Here are the top ten rules you should know about distributions from retirement accounts.
The First 5 Facts Apply to Traditional IRA and 401(k) Accounts.
1. Early Withdrawal Penalty. A distribution from a traditional IRA or 401(k) before the account owner reaches 59 1/2 causes a 10% early withdrawal penalty on the amount distributed. This is in addition to taxes owed on the amount distributed. So, for example, if you take a $10,000 distribution from your traditional IRA at age 45 then you will be subject to a $1,000 penalty and you will also receive a 1099-R from your IRA custodian and will need to report $10,000 of income on your tax returns. Once you reach age 59 1/2, the 10% early withdrawal penalty does not apply.
2. Required Minimum Distributions. Whether you need the money or not, at age 70 1/2, the IRS requires a traditional IRA or 401(k) owner (unless still employed by employer 401(k)) to begin taking distributions from their retirement account. These distributions are subject to tax and the account owner will receive a 1099-R of the amount distributed that will be included on their tax return. The amount of the distribution is based on the person’s age and the account’s value. For example, someone with a $100K IRA who has turned 70 1/2 and is taking their first RMD would take $3,639 (3.79%).
3. Avoid Taking Large Distributions In One-Year. Because distributions from traditional retirement accounts are subject to tax at the time of distribution, it is wise to avoid taking too much in one year as a large distribution can push your distribution income and your other income into a higher tax bracket. For example, if you have employment and or rental/investment income of $50,000 annually then you are in a joint income tax bracket of 15% on additional income. However, if you take $100,000 as a lump-sum that year this will push your annual income to $150K and you will be in a 28% income tax bracket. If you could instead break up that $100K over two tax years then you could stay in 15% to 25% tax bracket and could reduce your overall tax liability. In short, only pull out what you need when you need it to lesson the immediate year’s tax liability.
4. Distribution Withholding. Most distributions from an employer 401(k) or pension plan (including solo K), before the age of 59 1/2, will be subject to a 20% withholding that will be sent to the IRS in anticipation of tax and penalty that will be owed. In the case of an early distribution from an IRA, a 10% withholding for the penalty amount can be made but you can also elect out of this automatic withholding provided you make an estimated tax payment or that you will otherwise be current on your tax liability.
5. If You Have Tax Losses, Consider Converting to a Roth IRA or Roth 401(k). When you have tax losses on your tax return you may want to consider using those losses to offset income that would arise when you convert a traditional IRA or 401(k) to a Roth account. Whenever you convert a traditional account to a Roth account, you must pay tax on the amount of the conversion. In the end though, you’ll have a Roth account that grows entirely tax-free and that you don’t pay taxes on when you distribute the money. Using the losses when they are available is a good way to get your Traditional retirement funds over to Roth.
The Final 5 Rules are For Roth IRAs and Roth 401(k)s.
1. Roth IRAs Are Exempt from RMD. While traditional IRA owners must take required minimum distributions (“RMD”) when the account owner reaches age 70 1/2, Roth IRAs are exempt from RMD rules. That’s a great perk and allows you to keep your money invested as long as possible.
2. Roth 401(k)s Must Take RMD. Roth 401(k) designated accounts are subject to RMD. This is a confusing rule since Roth IRAs are NOT subject to RMD. Such is the tax code. How can you avoid this? Simply roll your Roth 401(k) funds over to a Roth IRA when you reach 70 1/2.
3. Distributions of Contributions Are Always Tax-Free. Distributions of contributions to a Roth IRA are always tax-free. Regardless of age, you can always take a distribution of your Roth IRA contributions without penalty or tax.
4. Distributions of Roth IRA Earnings. In order to take a tax-free distribution from a Roth IRA, you must be age 59 1/2 or older and you must have had a Roth IRA for five years or longer. As long as those two criteria are met, all amounts (contributions and earnings) may be distributed from a Roth IRA tax free. If your funds in the Roth IRA are from a conversion, then you must have converted the funds at least 5 years ago and must be 59 1/2 or older in order to take a tax-free distribution.
5. Delay Roth Distributions. Roth retirement accounts are the most tax efficient way to earn income in the U.S. As a result, it is best to distribute and use other funds and assets that are at your disposal before using the funds built up in your Roth account as those funds aren’t as tax efficient while invested.
By: Mat Sorensen, Attorney and Author of The Self Directed IRA Handbook
Self-directed 401(k) owners, companies in the industry, and many professionals have been confused on what rules, if any, govern when buying precious metals with a self-directed 401(k). There is a code section in IRC 408(m) that outlines what metals can be owned by a self-directed IRA and how they should be stored. I have an article that summarized those here. However, this section of the code is written for IRAs and many have questioned whether it should be applied to 401(k) accounts as well? The short answer is, yes, and here are two reasons why.
I. Most Solo K Plan Documents Adopt IRC 408(m).
Most 401(k) plans, including Solo 401(k)s, adopt IRC 408(m), which specify which precious metals your Solo K may own and provides a storage requirement. Since the plan documents restrict what precious metals your 401(k) may own, all accounts under the plan most follow the plan rules. Many may wonder, well can’t I just amend my 401(k) plan? Not exactly. Most Solo K plans are volume-submitter IRS pre-approved plans and take years to create and get approved with the IRS. A change requires approval from the provider of those plans and they’d have to change it for all their customers. This isn’t likely to occur, especially given point two below.
II. The IRS Wants Your Solo (k) to Follow the IRA Precious Metals Rule.
The IRS has issued guidance to 401(k) plans that are individually directed and has stated that the rules of IRC 408(m) should be followed when a 401(k) account purchases precious metals. To view the IRS analysis, check out their resource page here.
Consequently, Solo 401(k) owners buying precious metals should follow the IRA rules for precious metals and should only buy qualifying gold, silver, platinum, or palladium, and should make sure that such metals are stored with a third party qualifying institution (bank, credit union, or trust company).
Do you have a Solo 401(k)? Have you been filing form 5500-EZ each year for the Solo 401(k)? Are you aware that there is a penalty up to $15,000 per year for failure to file? While some Solo 401(k)s are exempt from the 5500-EZ filing requirement, we have ran across many Solo 401(k) owners who should have filed, but have failed to do so.
The return a Solo 401(k) files is called a 5500-EZ, and it is due annually on July 31st for the prior year. If you have a Solo 401(k) and you have no idea what I’m talking about, stay calm, but read on.
Benefits of Solo 401(k)s
One of the benefits of a Solo 401(k) is the ease of administration and control, because you can be the 401(k) trustee and administrator. However, as the 401(k) administrator and trustee, it is your own responsibility to make the appropriate tax filings. This would include filing any required tax returns for the 401(k). Solo 401(k)s with less than $250,000 in assets are exempt and do not need to file a 5500-EZ. All plans with assets valued at $250,000 or greater must file a form 5500-EZ annually. A tax return is also required for a Solo 401(k) when the plan is terminated, even if the plan assets are below $250,000. Recently, more and more Solo 401(k) owners have contacted us because they set up their Solo 401(k) online or with some other company, and were never made aware that they are supposed to file a 5500-EZ when their plan assets exceed $250,000. Some of these individuals have multiple years in which they should have filed the 5500-EZ, but failed to do so. The penalties for failing to file a 5500-EZ when it is required can be quite severe, with fees and penalties as high as $15,000 for each late return plus interest.
Failure to File Relief
Fortunately, the IRS has a temporary pilot program that provides automatic relief from IRS Late filing penalties on past due 5500-EZ filings. The penalty relief began as a temporary program in 2014 and was made permanent via Rev Proc 2015-32.
In order to qualify for this program, your Solo 401(k) plan must not have received a CP 283 Notice for any past due 5500-EZ filings, and the only participants of your Solo 401(k) plan can be you and your spouse, and your business partner(s) and their spouse. There is a $500 fee due for each delinquent return up to a total of $1,500 or three years. This program is available to all Solo 401(k) plans, regardless of whether it is a self-directed plan.
The IRS has provided details via Rev Proc 15-32. In order to qualify and receive a waiver of penalties under the program, you must follow the program exactly. In short, you must do all of the following:
- File all delinquent returns using the IRS form in the year the filing was due. This must be via paper form.
- Mark on the top margin of the first page, “Delinquent Return Submitted under Rev. Proc. 2015-32.”
- Complete and include IRS Form 14704.
- Mail all documents to the IRS, Ogden, UT office.
In sum, if you have a Solo 401(k) plan that should have filed a 5500-EZ for prior years, then you should take advantage of this program, which will save you thousands of dollars in penalties and fees. If you have any questions about this program or would like assistance with submitting your late 5500-EZ filings under this program, please contact our law firm as we are assisting clients with current and past due 5500-EZ filings for their Solo 401(k)s.
Solo 401(k) plans have grown significantly and are often used by self-directed investors. Solo 401(k)s are an excellent tool for self employed persons to maximize contributions in their own business or self-employment just like large companies who offer plans for their employees. The basic rules for solo 401(k)s are that you must be self-employed and that you must have a no other employees other than the business owner and family. As happens with many good things, this is starting to get over-sold and we are seeing common problems arise with persons who create them on-line or with the assistance of someone who has no credentials or experience outside of creating a catchy website. Here are a few things to watch out for.
Top Three Mistakes in Solo 401(k) Plans
1. Failure to Update/Amend– Pursuant to Revenue Procedure 2007-44, 401(k) plans shall be amended and restated every six years to conform with current law. The company who provided your plan document, usually what is called a pre-approved plan document for solo 401(k)’s, should be providing you with these updates so that your plan stays in compliance with the amendment cycles established by the IRS. Failure to properly update the plan can result in significant penalties and revocation of tax status.
2. Using an LLC With Rental Income as The Employer/Company – Solo 401(k)s must be established by an employer company. Unlike IRAs, where any individual may establish an account, a 401(k) may only be established by a company and is a benefit for its employees. For example, a solo 401(k) for a self-employed real estate agent with no other employees is created for the real estate agent who is the sole employee/owner. For many self-employed persons who have no other employees, this type of 401(k) is an excellent retirement plan too.
Unfortunately, the solo 401(k) is being oversold and over promoted to real estate investors who only own rentals. We have seen many promoters (operating out of a basement somewhere) who state that you can establish a solo 401(k) with your LLC that owns rental real estate. After all, they say, the LLC is a company and you are the only owner. Therefore this company can establish a solo 401(k). This is only partly true. The LLC that owns rental properties is not a proper entity in which to establish a solo 401(k) since the LLC receives “rental income” and since the owners of the LLC are not considered “employees” receiving wages or earned income that may be contributed to a retirement account. Rental income cannot be contributed to a retirement account and as a result the owner of the LLC is not an employee or person receiving earned income that qualifies to have a solo 401(k) account. All 401(k)s, solo 401(k)s included, must be established by a company for the benefit of its employees with wages or earned income. See IRS Publication 560. As a result, we recommend that clients use companies where there is wage income (e.g. s-corps) or self-employment income that creates earned income on schedule C be used to establish a solo 401(k). While an LLC may be used to adopt a solo 401(k), that would only be the case if the LLC receives ordinary income for its owner that is then claimed on schedule C of the owner’s tax return.
3. Failing to File Form 5500-EZ – In general, 401(k)s are required to file a return called from 5500. Solo 401(k)s, however, have some exemptions to the 5500 filing requirement but there are many situations where a solo 401(k) is still required to file an annual form 5500-EZ return. The first instance where a 5500-EZ tax return is required is when the solo 401(k) has over $250,000 in assets. The second instance is when the plan is terminated. Regardless of assets, a form 5500 must still be filed at termination.
Our law firm has experience in creating solo 401(k)s that can be self-trustee’d and self-directed and we also assist our clients with annual maintenance, plan amendments, and required annual 5500-EZ filings. Contact us at the law firm to learn more information about our services.
All retirement account owners must be familiar with the required minimum distribution (“RMD”) rules applicable to their accounts. These rules require you, in most instances, to take partial distributions from your retirement account when you reach age 70 ½. And, surprise, the rules for Traditional IRAs, Roth IRAs, and 401(k)s differ. In fact, even 401(k)s where you are a 5% or greater owner have different rules than 401(k)s where you aren’t an owner. Thanks, Congress.
So what rules apply to Solo 401(k) owners? Well, generally speaking, you must begin taking distributions from your Solo K when you reach age 70 ½. Despite what you may think or presume, there are three quirks to be aware of when it comes to RMD and Solo 401(k):
Still Working Exception Does Not Work on Solo Ks
There is a general RMD 401(k) rule which states that even after age 70 ½, you are not required to take distributions from an employer 401(k) when you are still working for that employer. However, this exception does not apply to account holders or their spouses who own 5% or more of the company. In other words, business owners who use a Solo 401(k) will be forced to take RMD from their Solo 401(k) after age 70 ½ even if they are still working in the business.
Roth 401(k) Funds are Subject to RMD
RMD applies to Roth 401(k)s. I know what you’re thinking, “Wait, but why would RMDs apply to Roth 401(k)s when Roth IRAs are exempt?” Because Congress said so. I know, it doesn’t make much sense, Roth 401(k) distributions at retirement will be tax-free, like Roth IRA distributions, and the IRS will not receive any revenue from the distribution so why treat Roth 401(k)’s differently? There’s not a good answer, but you should write your Congressperson or Senator and ask. In the meantime, if you’re 70 ½ and you have funds in a Roth 401(k) which you don’t want distributed, you can roll those Roth 401(k) funds out to a Roth IRA and you can avoid the distribution requirement by letting those funds sit in your Roth IRA where no RMD is required. Checkmate, IRS.
Every 401(k) Must Have RMD Taken, No Aggregating
Every 401(k) account you have must take RMD. So, for example, if you have a Solo 401(k) and a 401(k) account with an old employer then you need to take RMD from each 401(k) account. You cannot aggregate those accounts together and take RMD out of one to satisfy both RMD requirements. This aggregating is allowed in Traditional IRAs but unfortunately does not work with different 401(k) plan accounts. If taking RMDs from multiple accounts is getting too complex, you can roll the old employer 401(k) to the Solo K or to a Traditional IRA (or Roth IRA if Roth 401(k) funds) to consolidate your accounts and your RMD requirements.
Make sure take RMD when you are required to do so. Failure to take RMD results in a 50% penalty tax on the amount you failed to take. As a result, it’s critical that you understand the RMD rules for each retirement account you hold. If you have made a mistake though, the IRS does have penalty waiver programs whereby you can correct some failed RMDs and request a waiver of the penalty due. This doesn’t work in every instance, but if you’ve failed to take RMD ask your tax lawyer or accountant on whether a penalty waiver could apply in your instance.