Bankruptcy and Creditors’ Claims: Self-Directed Solo 401k | Solo 401k

When you as debtor declare bankruptcy, the majority of your assets become part of the bankruptcy estate. The bankruptcy estate then appoints a trustee to manage the bankruptcy estate, who uses assets from the bankruptcy estate to pay off your creditors. However, thanks to the Federal Bankruptcy Code, Self-Directed Solo 401k (also referred by other names such as Solo 401k, Solo k and Individual 401k) is excluded (that is, not subject to creditors claims) from the bankruptcy estate.

Congress passed in 2005 legislation that exempts qualified retirement plan (QRP) assets from bankruptcy estates under federal law (the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005). Further, ERISA (Employee Retirement Income Security Act of 1974) as well as IRC (Internal Revenue Code) detail that in order for a qualified plan such as a self-directed solo 401k to qualify as a retirement plan, it must list anti-alienation language. See ERISA Sec. 206(d) and IRC Sec. 401(a)(13).  

Court Case Supporting Exclusion from Creditors

Supreme Court case, Patterson V. Shumate--The Supreme Court ruled that anti-alienation provisions in the defendant's "ERISA-qualified" retirement plan had to be given effect under the bankruptcy rules. Since ERISA prohibits the assigning of benefits--even to a bankruptcy trustee, the retirement assets in that case were excluded from the bankruptcy estate.

The Bankruptcy Act of 2005

The passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 exempts rather than excludes under federal law, assets in employer-sponsored retirement plans established under IRC Secs. 401, 403, 408A, 414, 457, or 501(a). This law permits a debtor to choose to exempt employer-sponsored retirement plan assets from his or her bankruptcy estate, regardless of whether state or federal bankruptcy law is followed for purposes of exempting assets from the bankruptcy estate.

Solo 401k Plan Participant Loans Not Forgiven

Generally, in a bankruptcy proceeding, certain debtor obligations may be discharged (i.e., forgiven). But plan loans under this exemption are no dischargeable (11 U.S.C. Sec. 362(b)). This means that the loan is not forgiven. Instead, the loan must be either paid back or the outstanding balance treated as a taxable distribution.    

Rules/Handling IRS Levy Against: Self-Directed Solo 401k | Individual 401k

We all know that the IRS is responsible for collecting federal taxes; however, some of us may not be aware that if you do not pay your federal taxes the IRS may be able to levy (confiscate) your retirement funds including Solo 401k after satisfying timing and notice requirements.

The general rule or understanding in the retirement account industry regarding the IRS position on tax levies against retirement accounts is that a plan is not required to honor an IRS levy until the retirement account participant becomes eligible for a distribution from the plan (e.g., Self-Directed Solo 401k plan).  

This is supported by the following internal memorandums issued by the IRS whereby the IRS recognized the plan’s right to delay the distribution when the participant is not eligible to legally make/begin taking distributions.

• FSA 199930039 (Field Service Advice memorandum) and

• CCA 199936042 (Chief Counsel Advice memorandum)

The levy still attaches: The fact that the plan is not required to proceed with the levy until the Solo 401k participant is eligible to make a distribution does not mean that the levy is invalid before the plan funds are eligible for distribution. Instead, pursuant to IRC 6331 the levy sticks until distributions from the plan can legally commence. See Rev. Rul. 55-210, 1955-1 C.B. 544, which details the tax lien attaches to right to receive future benefits and that just one notice of levy is required to be served to have access to distributions form the plan once they qualify for distribution.

Self-Directed Solo 401k Contribution Deduction Facts (things to consider when taking tax deduction on your tax return for solo 401k yearly contribution amount)

IRC Sec. 404 allows employer (including self employed) to take a tax deduction for contributions made to a Solo 401k plan that do not exceed 25 percent of compensation (IRC Sec. 404(a)(3). This deduction is in addition to the salary deferral contribution deduction amount which is $16,500 for tax year 2011 and $17,000 for tax year 2012.

However, before taking the employer tax deduction (the 25% amount), first apply the IRC Sec. 401(a)(17) compensation cap which equals $245,000 for 2011 and $250,000 for 2012.  In other words, the compensation cap--the maximum amount of compensation that can be used to calculate your Solo 401k contribution amount--cannot exceed the aforementioned ceiling amounts. 

IRC Sec. 404(a)(6) permits the employer tax deduction (the 25% portion) even if the contribution for the immediate prior tax year is made in the following tax year as long as it's made before an employer's tax return due date plus (plus extensions).

A common false assumption about profit sharing deduction (the 25% contribution portion) limit (keep in mind that Solo 401k is made up of two types of contributions--profit sharing and salary deferral contributions) is that the 25 percent deduction limit applies on a per participant basis. However, the deduction limit applies on the basis of the aggregate eligible compensation earned by all Solo 401k plan participants (Solo 401k only allows for maximum of two participants--number of people who can contribute/participate to the plan) during   the employer's (self employed) tax year.

When calculating profit sharing contribution amount for deduction purposes, effective January 1, 2002 and after, compensation used to determine the employer's (self employed) maximum deductible contribution to a plan (including a Solo 401k plan) includes salary deferrals (the $16,500 for 2011 or $17,000 for 2012 contribution portion)

EXAMPLE: John and his wife sally are the only owners and employees of The Computer Company, a corporation, in aggregate they had $200,000 in income for 2011 of which they both contributed a combined total of $33,000 ($16,500 each) as salary deferral contribution to their solo 401k. When calculating their maximum employer contribution, they are not required to reduce the maximum deductible profit sharing deductible contribution by the salary deferral amount of $33,000.

In order to deduct contributions for a given tax year, the business owner is required to make contribution to Solo 401k by employer's tax return due date, including extensions as outlined in IRC Sec. 404(a)((6).

When calculating the 25 percent (employer contribution portion) Solo 401k contribution limit, the total employer (25%) contribution amount must be divided by the total compensation paid during the self employer tax year to all employees (note that Solo 401k only allows for maximum of two participants, usually husband and wife or two business partners) eligible to participate in the Solo 401k plan.

The compensation definition used for determining a self employer maximum deductible contribution includes salary deferrals [the $16,500 for 2011 or $17,000 for 2012].