How the SECURE Act Impacts Self-Directed Solo 401(k)s
The 2019 year-end domestic appropriations bill included the Setting Every Community Up for retirement Enhancement Act (SECURE ACT). The SECURE act contains several substantive changes to IRA and 401(k) based retirement plans.
While the law makes changes in a range of areas related to 401(k) plans, we wanted to outline the specific changes that may affect holders of a self-directed Solo 401(k).
Required Distributions Now Start at Age 72
The age at which one is required to start taking distributions from a 401(k) has been pushed back from 70½, to 72.
Individuals who would prefer to not take distributions will see this change as an incremental benefit. It’s also simpler to prepare for and manage distributions with a clean start-date of age 72. The 70 ½ age marker could be somewhat confusing.
The first distribution can be taken by the end of the year when the taxpayer turns 72, or delayed until April 1st of the following year. This means that someone turning 72 in 2022 can delay taking their first distribution until April 1, 2023.
The first distribution will be taken using the age 72 life expectancy factor.
When one chooses to delay the first RMD, there will be two distributions required in the first year. The normal 73rd year distribution will also need to be taken.
This change takes effect after December 31, 2019 and affects people who turn 70 ½ after that date. Those born before June 1, 1949 will be subject to the old rules.
New 10-Year Distribution Rule for Inherited Plans
The biggest change in the new law surrounds requirements for distributions from non-spousal inherited retirement plans.
Before the SECURE Act, a non-spousal inheritor of a plan could choose to take a full distribution of the account within a 5-year period or stretch distributions over their lifetime.
The capacity to stretch plan distributions over a longer term has been eliminated and replaced by a new 10-year rule. The entire inherited account must be distributed by the end of the 10th year from inheritance. A tax penalty of 50% the amount that should have been distributed applies if the account is not fully distributed by this time.
This rule applies to any account inherited after December 31, 2019, and will not impact existing non-spousal inherited plans.
The following “Eligible Designated Beneficiaries” are exempted from this requirement:
• Spouse
• Disabled beneficiaries (as defined in IRC Section 72(m)(7))
• Chronically Ill beneficiaries (as defined in IRC Section 7702B(c)(2))
• Individuals not more than 10 years younger than the decedent
• Certain minor children of the original account owner, but only until they reach the age of majority
For these Eligible Designated Beneficiaries, the old rules that allow for the use of a life expectancy based required minimum distribution apply.
Solo 401(k) Establishment Deadline
Self-employed individuals considering establishing a Solo 401(k) now have an extension of the time frame to do so.
Prior to the SECURE Act, a 401(k) had to be implemented by December 31 of the tax year to be able to accept contributions for the year.
You can now establish a plan up until the tax filing date of the business, including extensions, and will be able to treat the plan as if it has been established on the last day of the prior year. Your new plan can now accept contributions for the prior tax year.
This time extension only applies to plans funded via employer contributions, such as the profit-sharing component of the Solo 401(k). Employee contributions via salary deferral won’t be able to be made for the prior tax year in this situation.
Long-Term Part-Time Employees
This change could potentially impact Solo 401(k) qualification, including for existing plan sponsors.
The eligibility rules for 401(k) qualification now include any employee who works a minimum of 500 hours in 3 consecutive years.
The prior eligibility requirement was 1,000 hours of service in one year. This change applies to plans implemented after December 31, 2020, with 2021 being the first tax year that would count as a year of service if 500 hours were worked.
The first year that a plan would need to provide benefits to a long-term part-time employee is 2024.
Solo 401(k) plan sponsors who currently do not have any qualifying 1,000 hour per year employees but do have part-time workers under that threshold, an evaluation of plan suitability going forward will be in order.
$5,000 Early Distribution for Birth or Adoption
A new rule allows for a small early distribution from a retirement plan without a 10% penalty in the case of a new child.
A distribution of up to $5,000 may be taken penalty free within one year from childbirth or adoption of a child under the age of 18, any normal taxable amount would still be owed.
If both parents have a retirement plan, they can each distribute up to the $5,000 amount. A distribution may be taken for each child born or adopted and is not a one-time exception like a first-time home purchase.
In the future, the distributed amount can even be added back to the plan above and beyond any allowable contribution limit for a given year.
Increased Penalties for Failure to File
The fees for failure to file form 5500-EZ have been increased significantly, and could accrue at a rate of $250/day to a maximum of $150,000. As such, it’s critically important to file returns on a timely basis.
How do These Changes Impact Investors?
The delay in the start date RMDs will probably benefit many investors in a small way. Once someone is in their mid-to-late sixties, it becomes important to ensure that investments will produce the necessary liquidity to meet RMD requirements.
The clock starting later adds a bit of additional flexibility with respect to asset allocation.
The elimination of stretch distributions for inherited accounts is fairly significant.
Alternative asset investments in properties, limited partnership interests, mortgage notes and the like tend to be less liquid. The introduction of a fixed date by which plan investments need to be either liquidated or distributed in-kind could be problematic.
Inheritors of accounts will need to be cognizant of this timeline with respect to the asset allocation of the account. Investors deploying a self-directed 401(k) as part of a broader estate plan and a means to pass wealth to the next generations may need to revisit their strategy.
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