Business owners looking toward the horizon of their golden years will want to carefully consider what type of investments they should make. A Solo 401(k) is an excellent retirement plan for those who are lucky enough to be self-employed because it features high contribution limits and lower fees when compared to other types of retirement savings accounts.
Plus, you gain tons of flexibility on the investments you want to see within your portfolio of options when you opt for a Solo(k).
If you think this retirement savings vehicle could be the right move for you, here is what you need to know about the withdrawal rules of Solo 401(k)s.
Regular Withdrawal Rules for Solo 401(k)s
The advantages of a Solo(k) are clear for anyone looking for a solid way to start saving for their financial future into retirement. Still, savvy retirement savers should be aware of the withdrawal rules surrounding this type of account. Here are a few rules to consider before opening a solo 401(k).
5 Year Rule for Roth Accounts
The first important withdrawal rule to be aware of is the five-year rule. Your Solo(k) must be at least five years old before you start taking distributions to avoid the earnings from being taxed. The clock starts ticking on the day you make your first contribution to the account. This only applies to Roth accounts, and not to the pre-tax portion of your account.
The age of the account matters more than your age, with some people unable to utilize penalty-free withdrawals until well after the minimum required age.
If you were late to the game when it came to saving for retirement, you may have a few years to wait before you can withdraw your Roth account from a Solo 401(k).
Age Requirement
While you may meet the five-year rule relatively early on, you may still have to wait until you meet the age requirement.
If you are actively employed, you generally cannot take any distributions until age 59 ½. If you’re younger than 59 ½ and actively employed, you would need to terminate your employment in order to take a distribution.
If you’re no longer employed, you can make withdrawals before age 59 ½, but you might incur an early withdrawal penalty. After age 59 ½, you can withdraw from your account at any time, provided it’s permitted in the plan document.
Taxation Rules
There are two options for a Solo 401(k) when it comes to taxes: a Roth account or a traditional account.
Roth accounts are taxed upon depositing your contributions into the Solo(k), and you can avoid paying taxes when taking distributions in retirement, provided you meet the five-year rule and the minimum age requirement. This is good news if you think that you may be in a higher tax bracket in retirement.
On the other hand, a traditional Solo(k) is ideal for those who think they’ll be in a lower tax bracket in retirement. Your contributions will be made with pre-tax dollars, and you will pay your taxes based on the annual tax rate for your income bracket when you take distributions.
The ideal option is to use a combination of tax-deferred accounts and Roth accounts to minimize your tax liability.
Required Minimum Distributions
Some people prefer to put off their distributions until they reach a point of truly needing those funds. Maybe you decide to work for a few extra years because you love your career or you simply want to bolster those retirement savings accounts while you still can.
It’s important to note that you will have to take Required Minimum Distributions (RMDs) once you hit age 73.
How much you are required to withdraw is unique to you. It is calculated by devising the prior December 31 balance of that IRA or retirement plan account by a life expectancy factor. The IRS provides helpful worksheets and tables to help you calculate this amount.
If you don’t take these distributions, your plan will fall out of compliance and could be disqualified by the IRS. You will also miss out on some of the money that you worked hard to save, as the IRS penalizes 50 percent of what you should have taken as your distribution.
At Retire4one, not taking these distributions is not an option. Our office will process these automatically if we don’t hear back from you in order to ensure your plan is not penalized by the IRS.
Early Withdrawal Rules for Solo 401(k)s
Withdrawing your funds early is an option if you face a financial bind, but it will set you back more than you might imagine. It’s also important to note that you generally cannot be actively employed if you wish to make a withdrawal from any type of 401(k) plan.
Anyone who takes an early withdrawal from their Solo 401(k) before the minimum age of 59 ½ may face a 10 percent penalty on the amount they withdraw. In addition, you will need to pay income tax on the money that you take out of the retirement savings account.
Suppose that you wanted to withdraw $5,000 to cover an unexpected credit card bill that your savings account could not accommodate. The amount you are taxed will be determined by your tax bracket and the state where you reside when you file your personal taxes. If no election is made at the time of taking a hardship, a 10% federal tax will be withheld from the distribution.
You will not have to pay these fees and taxes upfront, as the IRS allows you to waive out of withholding and the penalty tax will be applied when you file your personal tax return. But while you can request and receive a $5,000 early withdrawal, you will likely have $1,000 in fees and taxes to account for when tax returns are due.
That being said, there are some plans that will allow for “hardship withdrawals” in certain circumstances that are beyond your control. Some of these situations can include:
- Funds to prevent eviction or home foreclosure of your principal place of residence
- Funeral costs for immediate family members
- College education costs for the participant, spouse, or any of their dependents
- Medical expenses (uninsured) for the participant, spouse, or any of their dependents
- Down payment for a house or principal place of residence
- Repairs on your current home that are needed as a result of a natural disaster
If you inherit a Solo 401(k) account after the passing of someone close to you, you will not incur any penalty for withdrawing funds. However, income tax rules will still apply to this inheritance.
Rollover and Loan Options
If you want to remove funds from your Solo(k) without paying taxes on them, you may be able to efficiently roll them over into a different type of account. This rollover generally incurs no taxes and may have more favorable rules when it comes to earlier withdrawals.
The catch here is that you must stick with the same type of retirement savings account – Roth or traditional.
For example, Roth Solo(k)s can be rolled over to Roth IRAs with no need to pay taxes. If you try to roll funds from a traditional 401(k) to a Roth IRA, you will owe taxes on the principal invested in the new account.
Some business investments or financially sticky situations may call for you to take a loan out of your Solo(k). The good news is that this does not trigger an early distribution penalty. However, you will need to pay the loan with interest (prime rate plus one to two percent depending on your plan). Loans can be made for up to 50 percent of the account value, capping out at $50,000. All payments paid on the loan will go back into the participant’s account.
All loans must be paid back in five years for most situations, or thirty years if used for the purchase of your primary residence.
Plan Termination
If you want to withdraw 100% of the funds in your Solo 401(k) account, you should investigate whether it’s best to simply terminate your plan. Working closely with a financial advisor and your plan provider to make this decision will help the process go smoothly.
For those who are actively employed, under age 59½, and wish to access 100% of the funds in their Solo(k), plan termination is the only way to do so.
During the termination process, you will need to transfer the assets to another retirement plan vehicle through a rollover or withdraw assets by taking a distribution.
Rollover: Transferring the funds into another eligible retirement plan. It’s generally best to roll pre-tax 401(k) funds to similar pre-tax accounts, like a traditional IRA or SEP IRA, in order to avoid triggering taxes. Similarly, Roth 401(k) funds should be transferred to Roth accounts like another Roth 401(k) or a Roth IRA.
Distribution: Withdrawing the funds from your account. Keep in mind that you may face an early distribution penalty of 10% if you are under age 59 ½. You will also owe income taxes if you’re withdrawing funds from a pre-tax Solo 401(k).
Get Help with Your Solo(k)
Setting up a Solo(k) is an advantageous move for any business owner’s retirement nest egg, but it may be challenging to find time in your busy day to get started.
Retire4one allows you to set up everything right from our website. In three to five minutes, you can get your Solo(k) Plan Document set up with us and make good use of our advantageous partnership with Voya. They will hold all your investments, giving you the advantage of a big employer but with a lower overall cost.
If you feel ready to tackle retirement savings plans as a self-employed professional, reach out to Retire4one today!