Have you taken a loan from your employer 401(k) plan and plan on leaving? Unfortunately, most company plans will require you to repay the loan within 60 days, or they will distribute the amount outstanding on the loan from your 401(k) account. Its one of the ways they try to keep their employees from leaving. “Don’t leave or we’ll distribute your 401(k) loan that you took from your money in your 401(k) account.”
How to Buy Yourself More Time & Avoid the Distribution
The good news is that following the Tax Cuts and Jobs Act (TCJA) you now have the option to re-pay the loan to an IRA to avoid the distribution and you have until your personal tax return deadline of the following year (including extensions) to contribute that re-payment amount to an IRA. By re-paying the amount outstanding on the loan to an IRA, you will avoid taxes and penalties that would otherwise arise from distribution of a participant 401(k) loan.
How It Works In Practice
Let’s say you left employment from your employer in February 2019 and that you had a 401(k) loan that was distributed by your employer’s plan following your termination of employment. You will have until October 15th of 2020 (if you extend your personal return, 6 month extension from April 15th) to make re-payment of the amount that was outstanding on the loan to an IRA. These funds are then treated as a rollover to your IRA from the 401(k) plan and your distribution and 1099-R will be reported on your federal tax return as a rollover and will not be subject to tax and penalty. While it’s not perfect it’s far great time than was previously allowed. Traditionally, you had 30 or 60 days at most to try to make re-payment.
The ability to rollover an outstanding 401(k) loan amount to an IRA is only available when you have left an employer (for any reason). It does not apply in instances where you are still employed and have simply failed to re-pay the loan or to make timely payments.
As 2018 comes to an end, it is critical that Solo 401(k) owners understand when and how to make their 2018 contributions. There are three important deadlines you must know if you have a Solo 401(k) or if you plan to set one up still in 2018. A Solo 401(k) is a retirement plan for small business owners or self-employed persons who have no other full time employees other than owners and spouses. It’s a great plan that can be self-directed into real estate, LLCs, or other alternative investments, and allows the owner/participants to contribute up to $55,000 per year (far faster than any IRA).
New Solo 401(k) Set-Up Deadline is 12/31/18
First, in order to make 2018 contributions, the Solo 401(k) must be adopted by your business by December 31st, 2018. If you haven’t already adopted a Solo 401(k) plan, you should start now so that documents can be completed and filed in time. If the 401(k) is established on January 1st, 2019 or later, you cannot make 2018 contributions.
2018 Contributions Can Be Made in 2019
Both employee and employer contributions can be made up until the company’s tax return deadline including extensions. If you have a sole proprietorship (e.g. single member LLC or schedule C income) or C-Corporation, then the company tax return deadline is April 15th, 2018. If you have an S-Corporation or partnership LLC, the deadline for 2018 contributions is March 15th, 2019. Both of these deadlines (March 15th and April 15th) to make 2018 contributions may be extended another six months by filing an extension. This a huge benefit for those that want to make 2018 contributions, but won’t have funds until later in the year to do so.
W-2’s Force You to Plan Now
While employee and employer contributions may be extended until the company tax return deadline, you will typically need to file a W-2 for your wages (e.g. an S-Corporation) by January 31st, 2019. The W-2 will include your wage income and any deduction for employee retirement plan contributions will be reduced on the W-2 in box 12. As a result, you should make your employee contributions (up to $18,500 for 2018) by January 31st, 2019 or you should at least determine the amount you plan to contribute so that you can file an accurate W-2 by January 31st, 2019. If you don’t have all or a portion of the funds you plan to contribute available by the time your W-2 is due, you can set the amount you plan to contribute to the 401(k) as an employee contribution, and will then need to make said contribution by the tax return deadline (including extensions).
Now let’s bring this all together and take an example to outline how this may work. Sally is 44 years old and has an S-Corporation as an online business. She is the only owner and only employee, and had a Solo 401(k) established in 2018. She has $120,000 in net income for the year and will have taken $50,000 of that in wage income that will go on her W-2 for the year. That will leave $70,000 of profit that is taxable to her and that will come through to her personally via a K-1 from the business. Sally has not yet made any 2018 401(k) contributions, but plans to do so in order to reduce her taxable income for the year and to build a nest egg for retirement. If she decided to max-out her 2018 Solo 401(k) contributions, it would look like this:
- Employee Contributions – The 2018 maximum employee contribution is $18,500. This is dollar for dollar on wages so you can contribute $18,500 as long as you have made $18,500. Since Sally has $50,000 in wages from her S-Corp, she can easily make an $18,500 employee contribution. Let’s say that Sally doesn’t have the $18,500 to contribute, but will have it available by the tax return deadline (including extensions). What Sally will need to do is let her accountant or payroll company know what she plans to contribute as an employee contribution so that they can properly report the contributions on her payroll and W-2 reporting. By making an $18,500 employee contribution, Sally has reduced her taxable income on her W-2 from $50,000 to $31,500. At even a 20% tax bracket for federal taxes and a 5% tax bracket for state taxes that comes to a tax savings of $4,625.
- Employer Contributions – The 2018 maximum employer contribution is 25% of wage compensation. For Sally: Up to a maximum employer contribution of $36,500. Since Sally has taken a W-2 wage of $50,000, the company may make an employer contribution of $12,500 (25% of $50,000). This contribution is an expense to the company and is included as an employee benefit expense on the S-Corporation’s tax return (form 1120S). In the stated example, Sally would’ve had $70,000 in net profit/income from the company before making the Solo 401(k) contribution. After making the employer matching contribution of $12,500 in this example, Sally would then only receive a K-1 and net income/profit from the S-Corporation of $57,500. Again, if she were in a 20% federal and a 5% state tax bracket, that would create a tax savings of $3,125. This employer contribution would need to be made by March 15th, 2019 (the company return deadline) or by September 15th, 2019 if the company were to file an extension.
In the end, Sally would have contributed and saved $31,000 for retirement ($18,500 employee contribution, $12,500 employer contribution). And she would have saved approximately $7,750 in federal and state taxes. That’s a win-win.
Keep in mind, you need to start making plans now and you want to begin coordinating with your accountant or payroll company as your yearly wage information on your W-2 (self employment income for sole props) is critical in determining what you can contribute to your Solo 401(k). Also, make certain you have the plan set-up in 2018 if you plan to make 2018 contributions. While IRAs can be established until April 15th, 2019 for 2018 contributions, a Solo K must be established by December 31st, 2018. Don’t get the two confused, and make sure you’ve got a plan for your specific business.
Note: If you’ve got a single member LLC taxed as a sole proprietorship, or just an old-fashioned sole prop, or even or an LLC taxed as a partnership (where you don’t have a W-2), then please refer to our prior article here on how to calculate your Solo K contributions as they differ slightly from the s-corp example above.
Late last week, the IRS announced increased contribution limits for IRAs, 401(k)s and other retirement plans. IRAs have been stuck at $5,500 since 2013, but are finally moving up to $6,000 starting in 2019. If you save in a 401(k), including a Solo K, the good news is that your contribution limits were increased too, with employee contributions increasing from $18,500 to $19,000 and total 401(k) contributions (employee and employer) reaching $56,000. The IRS announcement and additional details can be found here.
Health savings account (HSA) owners also won a small victory with individual contribution maximums increasing by $50 to $3,500, and family contribution amounts increasing by $100 to $7,000.
Here’s a quick breakdown on the changes:
- IRA contribution limitations (Roth and Traditional) increased from $5,500 to $6,000, and there is still the $1,000 catch-up amount for those 50 and older.
- 401(k) contributions also increased for employees and employers: Employee contribution limitations increased from $18,500 to $19,000 for 2019. The additional catch-up contribution for those 50 and older stays the same at $6,000. The annual maximum 401(k) (defined contribution) total contribution amount increased from $55,000 to $56,000 ($62,000 for those 50 and older).
- HSA contribution limits increased from $3,450 for individuals and $6,900 for families to $3,500 for individuals and $7,000 for families.
These accounts provide advantageous ways for an individual to either save for retirement or to pay for their medical expenses. If you’re looking for tax deductions, tax deferred growth, or tax-free income, you should be using one or all of these account types. Keep in mind there are qualifications and phase out rules that apply, so make sure you’re getting competent advice about which accounts should be set up in your specific situation. Lastly, remember, all of these accounts can be self-directed and invested into assets you know best.
You have a number of options and decisions to make when moving funds from a retirement account (401(k), 403(b), IRA) to an IRA. And you’ve got to be careful because sometimes checking the wrong box on your transfer, rollover, and withdrawal forms can have drastic tax consequences. For example, should you move funds from one retirement account to your IRA using a Direct Rollover, a 60-Day Rollover, or a Trustee-to-Trustee transfer? Which box do you check on your form and does a 1099-R get issued and reported to the IRS? Will I have to report anything on my tax return? Let’s go over the options and the consequences as well as the tax reporting for each one.
1. Direct Rollover from 401(k) to IRA – When Moving from an Employer Plan
A Direct Rollover is generally used when moving funds from an employer plan (e.g. former employer 401(k) or 403(b)) to an IRA). Under a direct rollover, the retirement plan administrator will send the retirement plan funds directly to the new custodian of your IRA. There is no tax consequence and there is no withholding. There is simply a “direct” rollover of the funds to the new IRA account. Most employer plans like 401(k)s and 403(b)s are traditional accounts, so those funds are generally rolled to a traditional IRA. If you are moving the funds to a Roth IRA, which is possible, you will need to covert the funds with the IRA custodian as they are being rolled into a Roth IRA. And of course, there are taxes due from the Roth conversion.
There are no limits on the number of Direct Rollovers you may complete, except as may be reasonably imposed by your employer’s retirement plan. For example, some employer plans may say that it’s an all or nothing option if you want to move funds once you no longer work there (e.g. keep all your funds there or move everything to an IRA).
If you are currently employed with your employer, you are usually only allowed to move funds from the employer’s plan when you have reached retirement plan age under the plan. This is usually 55 or 59 1/2 depending on your employer’s plan.
A direct rollover from an employer plan is not subject to tax or withholding. When a direct rollover is completed, a 1099 is generally issued from the current plan, but is marked as “not taxable” as the funds are being sent to another qualifying retirement account.
2. 60-Day Rollover – Only When You Need It This Way
A 60-Day Rollover allows you to take a distribution from one IRA, so long as you re-deposit that same amount into another IRA within 60 days, and the funds no longer considered distributed. When using a 60-Day Rollover, you receive the funds personally from the current IRA plan custodian, and then re-deposit those funds into a qualifying IRA within 60 days. Failure to re-deposit in time will cause a distribution of the funds, and you will be subject to taxes on any applicable penalties (e.g. early withdrawal penalty if under 59 1/2) for failure to re-deposit in time. There are no extensions, and there is no mercy if you miss the 60-day deadline. The new IRA custodian will generally require a certification, and your prior IRA account custodian’s statement to verify that the funds were in an IRA within the past 60 days.
It is very important to note that as of 2013 you can only complete one 60-Day Rollover every twelve months. See my prior article here on the 12-month rule for 60-Day Rollovers. Consequently, you should not use the 60-Day Rollover method option on a regular basis.
When using a 60-Day Rollover, the former IRA custodian will issue a 1099-R reporting the distribution as taxable and you will need to certify that you re-deposited within 60 days on your personal tax return to avoid the distribution. The 60-Day Rollover is communicated to the IRS on your personal tax return on line 15 where you report the distribution from the 1099-R, and then on line 15b you report that it was not taxable, since it was rolled over within 60 days. On line 15b, you indicate that the taxable amount is zero and you write the word Rollover next to line 15b. See the IRS instructions for line 15 here.
3. Trustee-to-Trustee Transfer – the Best Option When Changing IRA Custodians
The Trustee-to-Trustee transfer is the preferred method of moving funds from one IRA to another (e.g. from a Roth IRA at Fidelity to a Roth IRA with a self-directed custodian). Under a Trustee-to-Trustee transfer, the funds are sent from one IRA custodian (partial or full account) to your new IRA custodian. There is no tax, withholding, or penalty for moving funds via a Trustee-to-Trustee transfer, and there is no limit on the amount of Trustee-to-Trustee transfers you may complete.
A 1099-R is not issued when a Trustee-to-Trustee transfer occurs, and there is no withholding or tax due. Consequently, the Trustee-to-Trustee transfer is the preferred method to use when moving funds from one IRA to another.
Do you need access to your retirement account funds to start a business, pay for education expenses or training, make a personal investment, or pay off high interest debt? Rather than taking a taxable distribution from your 401(k), you can access a portion of the funds in your 401(k) via a loan from the 401(k) to yourself without paying any taxes or penalties to access the funds. The loan must be paid back to the 401(k) but can be used for any purpose by the account owner.
Many people are familiar with this loan option, but are confused at how the rules work. The loan rules from the IRS are the same whether it is your solo 401(k) or a 401(k) with your current employer. Here is a summary of the items to know. For more details, check out the IRS Manual on the subject here.
FAQs on Loans from Your 401(k)
How much can I loan myself from my 401(k)?
50% of the vested account balance (FMV of the account) of the 401(k) not to exceed $50,000. So if you have $200,000 in your 401(k) you can loan yourself $50,000. If you have $80,000, you can loan yourself $40,000. If your spouse has an account, they can take a loan from their 401(k) too under the same rules (50% of the account balance not to exceed $50K).
What can I use the funds for?
By law, the loan can be used for anything you want. The funds can be used to start a business, personal investment, education expenses, pay bills, buy a home, or any personal purpose you want. Some employer plans restrict the purpose of the loan to certain pre-approved purposes but that is less common. Most don’t place restrictions. If you used the funds for business purposes, then you can expense the interest you and your business are paying back to your 401(k).
How do I pay back the loan to my own 401(k)?
The loan must be paid back in substantially level payments, at least quarterly, within 5 years. A lump sum payment at the end of the loan is not acceptable. For loans where the funds were used to purchase a home, the loan term can be up to 30 years.
What interest rate do I pay my 401(k)?
The interest rate to be charged is a commercially reasonable rate. This has been interpreted by the industry and the IRS/DOL to be prime plus 2% (currently that would be 7% as prime is 5%). If the loan was for the purchase of a home for the account owner then the rate is the federal home loan mortgage corporate rate for conventional fixed mortgages. Keep in mind that even though you are paying interest, you are paying that interest to your own 401(k) as opposed to paying a bank or credit card company.
How many loans can I take?
By law, you can take as many loans as you want provided that they do not collectively exceed 50% of the account balance or $50,000. However, if you are taking a loan from a current company plan, you may be restricted to one loan per 12-month period.
What happens if I don’t pay the loan back?
Any amount not repaid under the note will be considered a distribution and any applicable taxes and penalties will be due by the account owner.
Can I take a loan from my IRA?
No. The loan option is not available to IRA owners. However, if you are self-employed or are starting a new business, you can set up a solo or owner-only 401(k) (provided you have no other employees than the business owners and spouses), then roll your IRA or prior employer 401(k) funds to your new 401(k), and can take a loan from your new solo 401(k) account.
Can I take a loan from a previous employer 401(k) and use it to start a new business?
Many large employer 401(k) plans restrict loans to current employees. As a result, you probably won’t be able to take a loan from the prior 401(k). You may, however, be able to establish your own solo or owner-only 401(k) in your new business. You would then roll over your old 401(k) plan to your new solo/owner only 401(k) plan, and would take a loan from that new 401(k).
Can I take a loan from my Roth 401(k) account?
Some plans restrict this, but it is possible to take a loan from the Roth designated portion of your 401(k).
What if I have a 401(k) loan and change employers?
Many employer plans require you to pay off any outstanding loans within 60 days of your last date of employment. If your new employer offers a 401(k) with a loan option, or if you establish a solo/owner-only 401(k), you can roll over your prior employer loan/note to your new 401(k). Also, many plans have waivers to avoid total payoff (not payments) and give you time for repayment if you leave employment.
The 401(k) loan option is a relatively easy and efficient way to use your retirement account funds to start a small business, to pay for non-traditional education expenses, or to consolidate debt to a better rate of interest. If you have more questions about accessing your 401(k) funds, please contact us our attorneys at KKOS Lawyers by phone at (602) 761-9798 or visit kkoslawyers.com.