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Funding Your New Solo 401(k) with Last Year’s Money

NOTE:  Passage of the SECURE Act in 2019 renders this strategy obsolete.  With the new law, one can establish a Solo 401(k) up until the date of the tax-filing deadline of the sponsoring employer, including extensions.  This plan can then accept employer profit-sharing contributions for the prior plan tax year.  Employee deferrals, however, are only allowed to be made with income received after the date of plan formation.

One of the great things about a Solo 401(k) plan is the high contribution limits. As of 2019, you can set aside up to $62,000 into a Solo 401(k). This allows you to build your retirement savings generously on the front end, as well as create a significant tax exemption.

As tax filing deadlines approach, the ability to make such plan contributions is a big draw for a lot of investors. Unfortunately, a brand new Solo 401(k) doesn’t have the ability to accept contributions for the prior tax year. You may only start making contributions into a Solo 401(k) in the year the plan is established.

For a lot of investors who first learn about a Solo 401(k) in March or April, this can put a damper on tax season.

Fortunately, there’s an easy workaround that allows you to take advantage of your self-directed Solo 401(k) by looking back in time to make a generous prior-year contribution. We call this strategy a SEP to Solo 401(k) Bridge.

Qualified Self-Employment

A Solo 401(k) is a simplified version of an employer sponsored 401(k) plan designed for an owner-only business.

To be eligible for a Solo 401(k), you must have some form of self-employment that generates earned income. Your business and any other business you may control may not have any full-time employees other than you or your spouse.

The good news is, if you qualify for a Solo 401(k), you also qualify for a SEP IRA. A SEP IRA is a Simplified Employer Pension plan that allows for generous employer profit-sharing contributions that are much higher than an individual can contribute to a Traditional IRA. In fact, the top limit of the SEP IRA is similar to the Solo 401(k), at $56,000.

Most importantly, you can establish and fund a SEP IRA up until the tax filing deadline for the business sponsoring the plan, including extensions. That means you have until September 15th for a sole proprietorship or other pass-through entity, or October 15th for a corporation.

Note: This strategy only works if your self-employment activity was in place during the prior tax year.

Establishing a SEP IRA

If your intention is to create a self-directed Solo 401(k), then the SEP IRA that you setup will be temporary in nature. You will only use the account for the purpose of making a prior year contribution. Once the contribution is made, you will shut down the SEP IRA and roll over the funds to your new Solo 401(k).

With this in mind, focus on simplicity and cost when establishing a SEP IRA. Many banks or credit unions can setup a SEP IRA for you easily. You can also go to a mainstream online brokerage to set up this type of account.

You’re not going to be overly concerned with investment choices, and will likely only want to put the contributed funds into something from which it’s easy to transfer, such as cash or a money market account. If you choose to work with a bank or credit union, be sure not to get trapped into a long-term CD, which can sometimes be the default investment option if you don’t specify otherwise.

Most mainstream banks and brokerages don’t typically have significant account closure fees, but be sure to check on that detail. You will be closing the account relatively shortly.

Making a SEP IRA Contribution

Work with your licensed tax advisor to evaluate the maximum amount you’re eligible to contribute to your SEP IRA, and other issues of your business tax return and tax strategy.

The contribution rules for a SEP IRA are similar to the profit-sharing component of the Solo 401(k). The business may make a contribution to your participant account up to 25% of your self-employment income or wage compensation from your business with a maximum amount of $56,000.

Establish your Solo 401(k) Plan

You can set up your new Solo 401(k) plan at any time, either during the time you’re working on a prior-year SEP IRA, or after that process has been completed. Since the plans apply to different tax years, there are no concerns about overlap.

If a main source of funding for your new Solo 401(k) will be the prior year contributions being made to your SEP IRA, then it may make sense to wait until you’re almost finished with the SEP contribution to setup your Solo 401(k).

If you also have a rollover from a prior employer plan or IRA that will be funding your new Solo 401(k), you can get the Solo 401(k) started at any time. This would allow you to setup the new plan, rollover funds, and start investing immediately — even if it may take some time to prepare your prior year tax return and contribute to the SEP IRA.

Rollover Your SEP to Your Solo 401(k)

Once your Solo 401(k) plan is in place and the prior year contribution has been made to the SEP IRA, you can rollover your SEP IRA to your Solo 401(k). This event is a non-taxable plan-to-plan rollover. Your SEP IRA can then be shut down.

The Best of Both Worlds

With this simple SEP to Solo 401(k) bridge strategy, you can take advantage of the many benefits the Solo 401(k) provides as a self-directed investing platform, while also getting a big tax deduction for the previous year. Contact us today with any strategy questions or concerns for your SEP IRA or Solo 401(k) »


This page has been updated to reflect law changes implemented with the SECURE Act of 2019.

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