Solo 401(k)s have become a popular retirement plan option for self-employed persons. Unfortunately, many of the plans are not properly maintained and are at the risk of significant penalty and/or plan termination. If you have a Solo 401(k), you need to ensure that the 401(k) is being properly maintained. Here’s a quick checklist to make sure your plan is on track.
- Is the Plan Up-to-Date? The IRS requires all 401(k) plans, including solo 401(k)s, to be amended at least once every 6 years. If you’ve had your plan over 6 years and you’ve never restated the plan or adopted amendments, it is not compliant and upon audit you will be subject to fines and possible plan termination (IRS Rev Proc 2016-17). If your plan is out of date, your best option is to restate your plan to make sure it is compliant with current law. On average, most plan documents we see update every 2-3 years as the laws effecting the plan documents change.
- Are You Properly Tracking Your Plan Funds? Your solo 401(k) plan funds need to be properly tracked and they must identify the different sources for each participant. For example, if two spouses are contributing Roth 401(k) employee contributions and the company is matching traditional 401(k) dollars, then you need to be tracking these four different sources of funds, and you must have a written accounting record documenting these different fund types.
- Plan Funds Must Be Separated by Source and Participant. You must maintain separate bank accounts for the different participants’ funds (e.g. spouses or partners in a solo K), and you must also separate traditional funds from Roth funds. In addition, you must properly track and document investments from these different fund sources so that returns to the solo 401(k) are properly credited to the proper investing account.
- Does Your Solo 401(k) Need to File a Form 5500? There are two primary situations where you may be required to file a Form 5500 for your solo 401(k). First, if your solo 401(k) has more than $250,000 in assets. And second, if the solo 401(k) plan is terminated (regardless of total asset amount). If either of these instances occur, then the solo 401(k) must file a Form 5500 to the IRS annually. Form 5500 is due by July 31 of each year for the prior year’s plan activity. Solo 401(k)s can file what is known as a 5500-EZ. The 5500-EZ is a shortened version of the standard Form 5500. Unfortunately, the Form 5500-EZ cannot be filed electronically and must be filed by mail. Solo 401(k) owners have the option of filing a Form 5500-SF on-line through the DOL. The on-line filing is a preferred method as it can immediately be filed and tracked by the plan owner. In fact, if you qualify to file a 5500-EZ, the IRS/DOL allow you file the Form 5500-SF on-line but you can skip certain questions so that you only end up answering what is on the shorter Form 5500-EZ.
- Are You Properly Reporting Contributions and Rollovers? If you’ve rolled over funds from an IRA or other 401(k) to your solo 401(k), you should’ve indicated that the rollover or transfer was to another retirement account. So long as you did this, the company rolling over the funds will issue a 1099-R to you, but will include a code on the 1099-R (code G in box 7) indicating that the funds were transferred to another retirement account, and that the amount on the 1099-R is not subject to tax. If you’re making new contributions to the solo 401(k), those contributions should be properly tracked on your personal and business tax returns. If you are an s-corp, your employee contributions should show up on your W-2, and your employer contributions will show up on line 17 of your 1120S s-corp tax return. If you are a sole prop, your contributions will typically show up on your personal 1040 on line 28.
Make sure you are complying with these rules on an annual basis. If your solo 401(k) retirement plan is out of compliance, get with your attorney or CPA immediately to make sure it is up-to-date. Failure to properly file Form 5500 runs at a rate of $25 a day up to a maximum penalty of $15,000 per return not properly filed. You don’t want to get stung by that penalty for failing to file a relatively simple form. The good news is there are correction programs offered for some plan failures, but don’t get sloppy, or you’ll run the risk losing your hard-earned retirement dollars.
As 2015 comes to an end, it is critical that Solo 401(k) owners make year-end retirement plans. 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 2015. 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 that allows the owner to contribute up to $53,000 per year (far faster than any IRA).
NEW SOLO 401(K) SET-UP DEADLINE IS 12/31/15
First, in order to make 2015 contributions the solo 401(k) must be adopted by your business by December 31, 2015. If you haven’t already adopted a Solo 401(k) plan, you should be starting right now so that documents can be completed and filed in time. If the 401(k) is established on January 1, 2016, or later you cannot make 2015 contributions.
2015 CONTRIBUTIONS CAN BE MADE IN 2016
Second, both employee and employer contributions can be made up to the company’s tax return deadline INCLUDING extensions. If you have a sole proprietorship (e.g. single member LLC or schedule C income) or partnership then the tax return deadline is April 15, 2016. If you have an s-corporation or c-corporation, then the tax return deadline is March 15, 2016. Both of these deadlines may be extended 6 months by filing an extension and the date to make 2015 contributions will also be extended. This a huge benefit for those that want to make 2015 contributions but who won’t have funds until later in the year to do so.
W-2’s FORCE YOU TO PLAN NOW
Third, 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 31, 2016. 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 $18,000 for 2015) by January 31, 2016 or you should at least determine the amount you plan to contribute so that you can file an accurate W-2 by January 31, 2016. 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. Let’s take Sally who is a real estate professional and who owns an s-corporation. She is the only owner and only employee and has a solo 401(k) established in 2015. 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 2015 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 2015 Solo 401(k) contributions, it would look like this.
- Employee Contributions – The 2015 maximum employee contribution is $18,000. This is dollar for dollar on wages so you can contribute $18,000 as long as you have made $18,000. Since Sally has $50,000 in wages from her s-corp, she can easily make an $18,000 employee contribution. Let’s say that Sally doesn’t have the $18,000 to contribute but will have it available by the tax return deadline (including extensions). What Sally will need to do is she will 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 $18,000 employee contribution, Sally has reduced her taxable income on her W-2 from $50,000 to $32,000. At even a 20% tax bracket for federal taxes and a 5% tax bracket for state taxes that comes to a tax savings of $4,500.
- Employer Contributions – The 2015 maximum employer contribution is 25% of wage compensation for Sally. 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 employee benefit expense on the s-corporations 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 15, 2016 (the company return deadline) or by September 15, 2016 if the company were to file an extension.
- In the end, Sally would have contributed and saved $30,500 for retirement ($18,000 employee contribution, $12,500 employer contribution). And finally, she would have saved $7,625 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 account or payroll company as your yearly wage information and W-2 are critical in determining what you can contribute to your Solo 401(k).
By: Mat Sorensen, Attorney and Author of The Self Directed IRA Handbook
It’s time to start thinking about year-end tax planning and as every savvy business owner knows, effective 2015 tax planning happens before December 31, 2015. One of the most commonly used strategies for our clients is an s-corporation and a 401(k). A properly structured s-corporation is utilized best for tax purposes when the business owner adopts and contributes to a 401(k) plan as the contributions to 401(k) are tax deductible. Whether the business has only one owner/employee (or spouses only) or whether the business has dozens or even hundreds of employees, a 401(k) is a great tool to help defer taxable income. Simply put, a 401(k) plan can be used as a tool for putting the income of the business owner (and applicable employees) away for retirement with the added benefit of a tax deduction for every dollar that can be contributed. There are numerous benefits and options in a 401(k) plan. For example, you can do Roth 401(k) account, you can self direct a 401(k) account, and you can even loan money to yourself from your 401(k) account. While books have been written about all of these options and benefits, one of the most misunderstood concepts of 401(k) plans is how s-corporation owners can contribute their income to the plan. That is the focus of this article.
In order to understand how s-corporations income can be contributed to a 401(k) plan, you need to understand the following three basic rules.
- Only W-2 Salary Income can be Contributed to a 401(k). You cannot make 401(k) contributions from dividend or net profit income that goes on your K-1. See IRS.gov for more details. Since many s-corporation owners seek to minimize their W-2 salary for self-employment tax purposes, you must carefully plan your W-2 and annual salary taking into account your annual planned 401(k) contributions. In other words, if you cut the salary too low you won’t be able to contribute the maximum amounts. On the other hand, even with a low W-2 Salary from the s-corporation you’ll still be able to make excellent annual contributions to the 401(k) (up to $18,000 if you have at least that much in annual W-2 salary).
- Easy Elective Salary Deferral Limit of $18,000 or 100% of Your W-2, whichever is less. If you have at least $18,000 of salary income from the s-corporation, you can contribute $18,000 to your 401(k) account. Every employee under the plan is allowed to make this same contribution amount. As a result, many spouses are added to the s-corporation’s payroll (where permissible) to make an additional $18,000 contribution for the spouse’s account. If you are 50 or older, you can make an additional $6,000 annual contribution. Follow this link for the details from the IRS on the elective salary deferral limits. The elective salary deferral can be traditional dollars or Roth dollars.
- Non-Elective Deferral of 25% of Income Up to a $53,000 total Annual 401(k) Contribution. This is usually maximized best in solo 401(k) plans where you as the business owner decided to offer them most generous company match allowed by law (25% of wages). Rarely is this offered or maximized like this in a group 401(k) scenario where you have other employees because what you offer yourself, you must offer to all employees who qualify for the plan (full-time, worked for you a year, over 21). If you are in the solo 401(k) situation, this additional 25% deferral is an excellent tool because in addition to the $18,000 annual elective salary contribution, an s-corporation owner can contribute 25% of their salary compensation to their 401(k) account up to a maximum of a $53,000 total annual contribution. This non-elective deferral is always made with traditional dollars and cannot be Roth dollars. So, for example, if you have an annual W-2 of $100,000, you’ll be able to contribute a maximum of $25,000 as a non-elective salary deferral to your 401(k) account. If you have employees who participate in the plan besides you (the business owner) and your spouse, then the non-elective deferral calculation gets much more complicated because you’d have to offer it to those employees too. But for now, let’s assume there are no other employees and run through the examples.
Let’s run through two examples. The first is an s-corporation business owner looking to contribute around $30,000 per year. The second is a business owner looking to contribute the maximum of $53,000 a year.
Example 1, Seeking a $30,000 Annual Contribution.
S-Corporation Owner W-2 Salary = $50,000
Elective Salary Deferral = $18,000
25% of Salary Non-Elective Deferral = $12,500 (25% of $50,000)
Total Possible 401(k) Contribution = $30,500
Example 2. Seeking Maximum $52,000 Annual Contribution
S-Corporation Owner W-2 Salary = $140,000
Elective Salary Deferral = $18,000
25% of Salary Non-Elective Deferral = $35,000 (25% of $140,000)
Total Possible 401(k) Contribution (maximum) = $53,000
As a result of the calculations above, in order to contribute the maximum of $53,000, you need a W-2 salary from the s-corporation of $140,000. Keep in mind that if you have other employees in your business (other than owner and spouse) that you are required to do comparable matching on the 25% non-elective deferral and as a result such maximization is often difficult to accomplish in 401(k)s with employees other than the owner and their spouse. Consequently, the additional 25% non-elective salary deferral is best used in owner only 401(k) plans. If you do have employees though you can at least do $18,000 per year without having a matching requirement for your employees. That’s still three times what you can contribute to a traditional or a roth IRA. There are also common matching formulas used where you end up matching yourself and your employees contributions at a rate of 4% of salary (safe harbor).
Keep in mind that while 401(k) contributions can be made until the tax return deadline (personal, 4/15/16 and s-corp 3/15/16), including extensions, that the 401(k) must be established before the end of 2015 in order to later make 2015 contributions. As a result, you just need to establish the 401(k) before the end of 2015 and that will allow you to later make 2015 contributions prior to filing your 2015 returns.
Self-employed persons have two options when it comes to establishing a retirement account. If you are self-employed and you want to save for retirement, two of your primary options will be a SEP IRA or a Solo 401K. The SEP IRA is a super-charged IRA account that runs off of IRA rules while the Solo 401(K) is an employed based retirement plan used solely for the business owner(s) when they have no other employees.
Both a SEP IRA and a Solo 401(k) can be self-directed and invested into real estate, private company stock, or precious metals. Under a SEP IRA, you will have a self-directed IRA custodian. Under a Solo 401K, you can serve as your own trustee and administrator or you could use a custodian.
While a SEP IRA and a 401(k) can be used by business owners with employees other than the business owners, this article compares the two account options for those who are self-employed with no other employees other than themselves (and partners and family).
|SEP IRA||Solo 401K|
|Contribution Max||$53,000 max annual contribution (it takes $265K of self-employment income to max out). Contributions are all employer contributions.||$53,000 max annual contribution (it takes $140K of wage/se income to max out). Contributions are employee and employer. Because a solo K is easier to max out each year on less income, it gives greater opportunity for utilization over the SEP IRA.|
|Traditional & Roth||All SEP contributions are traditional dollars and all funds in a SEP must be traditional dollars. SEP IRA funds can be converted to a Roth IRA though.||A solo 401(k) can have a traditional account and a roth account within the same plan. You can convert traditional sums over to Roth as well. Because you can have Roth accounts and Traditional account in the 401K, that provides more options in the solo 401(k).|
|Contribution & Establishment Deadline||Date of the company tax return INCLUDING extensions. You may also establish a new SEP IRA at the time you make the first contributions even if that is for the prior tax year. For people making contributions for the first time for a prior year (e.g. in April of 2015 for 2014 contributions), this is a big benefit as a 401K) cannot be used unless it was set up in the tax year of the contribution.||Date of the company tax return INCLUDING extensions. However, for new plans, they must be established by December 31 of the year you are seeking to make contributions. This means you have to plan ahead and establish the 401(k) before the end of the year.|
|Custodian Requirement||An IRA must have a third party custodian involved on the account (e.g. bank. Credit union, trust company) who is the trustee of the IRA.||A 401(k) can be self trusteed, meaning the business owner can be the trustee of the 401(k). This provides for greater control but also greater responsibility.|
|Investment Details||A SEP IRA is invested through the self directed IRA custodian. A SEP IRA can be subject to a tax called UDFI/UBIT on income from debt leveraged real estate.||A Solo 401(k) is invested by the trustee of the 401(k) which could be the business owner. A solo 401(k) is exempt from UDFI/UBIT on income from debt leveraged real estate.|
In sum, there are many differences between a solo 401(K) and a SEP IRA but the solo 401(k) has proven to be an excellent tool that provides greater flexibility when saving and investing for retirement.
Do you need access to your retirement account funds to start a business, to pay for non-traditional education expenses, to make a personal investment, or to 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. Here is a summary of the items to know. For more details, check out the IRS Manual on the subject here.
FAQ’s 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 a $200,000 401(k) account value you can loan yourself $50,000. If you have $80,000, you can loan yourself $40,000.
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, for personal investment, for education expenses, to pay bills, to buy a home, or for any personal purpose you want. Some employer plans restrict the purpose of the loan to certain pre-approved purposes.
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, with-in 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 5.75%). 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 re-paid 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) and you can 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.
Can I take a loan from my Roth 401(k) account? Yes, so long as your 401(k) plan doesn’t restrict loans from the Roth account.
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).
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 at the law firm at 602-761-9798.
By: Mat Sorensen, Attorney & Author of The Self Directed IRA Handbook.