The benefit of owning a self-directed Solo 401(k) is to leverage the tax-sheltered savings structure of the plan to create wealth for our golden years. When those retirement years arrive, we have the opportunity to draw down some of that savings to ourselves in the form of distributions.
But before taking any distributions, there are important rules and considerations you should know about your account. From early distributions to required minimum distributions, read on to discover 7 key considerations for Solo 401(k) distributions.
1. Early Distributions
The tax code discourages distributions prior to retirement age. Unless considered one of a handful of IRS allowed exceptions for severe financial hardship, qualified educational use, disability, or the first-time purchase of a primary residence, any distribution of tax-deferred 401(k) savings prior to age 59 1/2 will be subject to normal taxes as well as a 10% penalty.
With passage of the SECURE Act in 2019, a new exception was created allowing for a $5,000 non-penalized early distribution in the case of the birth of a child or adoption of a child under the age of 18.
2. Normal Distributions
Normal retirement age is 59 ½. After this point, you can start taking distributions from your plan without incurring a 10% penalty for early distribution.
You’re allowed to take distributions from your Solo 401(k) even if you’re still actively working in your self-employment business, and even if you are also continuing to make new plan contributions.
In most circumstances, you wouldn’t both contribute and distribute, but it’s technically feasible to do so.
Distributions from a tax-deferred account will be taxed as regular income to you. Qualified Roth distributions will be tax-free.
3. Qualified Roth Distributions
In order to have the full tax-free status accorded to Roth accounts, a Roth distribution must be deemed qualified. This means the distribution must be after a 5-year taxable period of participation, and after reaching age 59 ½.
If the distribution is taken by an inheritor after your death, or by you as a result of disability prior to age 59 ½, it will also be qualified.
This means that if you setup a Solo 401(k) at age 57 and make a Roth contribution in that first year, you must wait until age 62 before taking distributions in order for the entire amount to be tax-free.
If you setup a Solo 401(k) at age 50, but only made tax-deferred contributions until age 56, at which point you started making Roth contributions, then you would first be able to start taking fully tax-free distributions from the Roth account in your 61st year.
4. Non-Qualified Roth Distributions
If a Roth distribution is non-qualified, then the earnings portion of the distribution is taxable.
Unlike in an IRA where there is a first-in first-out logic applied to contributions, conversions, and earnings, all Roth 401(k) distributions are treated on a pro-rata basis. This means that if you have a non-qualified distribution, you must calculate which portion is non-taxable basis and which is taxable earnings.
To make this calculation, you will first determine the ratio of contributed Roth basis to the current value of the Roth account. If you contributed $20,000 over a period of years to the Roth account and it has now grown to $25,000, then any distribution will be 88% basis and 12% earnings.
If you were to distribute $5,000 in a non-qualified fashion, then $600 would be taxable and included as income on your tax return. The remaining $4,400 would be non-taxable.
5. Required Minimum Distributions
Starting in the year in which you reach 72 years of age, you are obligated to start taking Required Minimum Distributions (RMDs) from your Solo 401(k). Note that the 72nd year starting age first goes into effect after December 31st, 2019 per the SECURE Act. For those born before June 1st, 1949, the prior RMD starting age of 70 1/2 applies.
The requirement to take distributions applies to both the tax-deferred and the Roth accounts of your 401(k) plan. Because of this requirement to take distributions from a Roth 401(k), many investors will rollover their Roth 401(k) balance to a Roth IRA. A Roth IRA is not subject to Required Minimum Distributions.
When you’re subject to RMDs, you must use an IRS-mandated formula to determine the minimum amount that you must distribute from each plan account. This calculation is based on one of a handful of life-expectancy tables.
The table will provide a factor for each year of age that you multiply by the account value as of December 31st of the prior year.
If you have both tax-deferred and Roth accounts within your Solo 401(k), you must perform separate calculations and distribute accordingly from each account.
Failure to take the required distribution results in a tax penalty of 50% of the amount you should have distributed.
While you’re required to take a certain amount from your plan, you’re always able to take a larger amount if you choose.
6. Distribution Process
With a self-directed Solo 401(k), you are the plan administrator. This means you are responsible for recordkeeping to track the values of your respective plan accounts, executing plan distributions, and performing the necessary tax filings.
We strongly recommend you work with your licensed tax advisor on 401(k) distributions.
The act of taking a Solo 401(k) distribution is easy. You just issue funds from the plan to yourself.
However, on the back end, there are a few activities you need to document to make this a legitimate distribution.
If you have multiple accounts such as husband & wife or tax-deferred & Roth, you will need to update your plan ledger to indicate which participant account(s) funds were distributed from and update the current value of those accounts.
7. Reporting and Withholding
As the plan administrator, you must withhold 20% of the distributed amount. These withholdings must be made using the Electronic Federal Tax Payment System (EFTPS) by the 15th of the month following the distribution event.
IRS form 945 is filed by January 31st to report all withholdings in the prior tax year.
IRS form 1099-R must be produced and submitted to the IRS by February 28th in the year following distributions.
Distributions will also be reported on your personal tax return.
If you have any questions about these Solo 401(k) distribution rules, don’t hesitate to reach out and contact us for expert advice and guidance »
This page has been updated to reflect law changes in the SECURE Act of 2019.