Question: I am self-employed and it looks like I will be making some money this year and I would like to save it for retirement and shelter it from income tax. My tax professional told me to look into a Solo 401(k) plan, which would allow me to save even more than just my current SEP (Self-employed IRA). I still have my SEP IRA account, but would like to save more than it will allow me to contribute. What is the difference between the SEP and the Solo 401(k)?
Answer: Your advisor gave you good advice. Solo 401(k) plans are great for self-employed taxpayers who have no employees, have net incomes of less than $265,000, and who want to shelter more than 20% of their net income from taxes.
With your SEP IRA you are able to contribute 20% of your net self-employment income up to $53,000 for 2015. With a Solo 401(k) you can contribute the same 20% of your net income, plus an additional $18,000 up to a combined total of $53,000. And if you are age 50 or over, you can make an additional $6,000 catch-up contribution this year.
For example, if your net self-employed compensation is $100,000 then your maximum SEP-IRA contribution is $20,000. With a Solo 401(k) you can contribute $20,000 plus a defined contribution of $18,000, for a total of $38,000. If you are 50 or over, you could contribute and defer taxes on an additional $6,000, for a grand total $44,000.
Question: I recently read that owners of Solo 401(k) plans with values exceeding $250,000 must file a tax return for the plan. Is this correct? Is my SEP IRA balance included in the $250,000 limit? Must I file a tax return for my Solo 401(k) retirement plan?
Answer: When your Solo 401(k) plan exceeds $250,000, you are required to file a tax return for the plan using IRS Form 5500-SF or Form 5500-EZ. The $250,000 does not include the money in your SEP-IRA and there is no requirement for you to file a tax return for your SEP-IRA regardless of the amount in the account.
If your Solo 401(k) plan value exceeds $250,000 at the end of the year and you fail to file a tax return for the plan, you are subject to a penalty of $25 per day up to $15,000. Solo 401(k) plan owners who should have filed and did not should consult with their tax professional for advice.
Question: Is there a way to avoid the requirement to file tax returns for my Solo 401(k)?
Answer: Yes, but only if your 401(k) plan documents allow you to make distributions while you are still actively working. If that’s the case, you can make direct rollovers of funds from your Solo 401(k) to an IRA account (including your SEP IRA) to keep your Solo 401(k) plan balance below the $250,000 reporting threshold.
Question: Can I borrow money from my Solo 401(k)?
Answer: Yes, if the plan document allows it you can borrow from your account.
Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment manager and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning. Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA93940 or email them to firstname.lastname@example.org.