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].

Solo 401k Contribution Limits

Solo 401k | Solo 401k Contributions | Solo 401k Contribution Limits 


Periodic or Lump Sum: Annual Solo 401k contributions can be made throughout the plan year or lump sum by the self employer tax return due date plus extensions (generally October 15)

IRC Sec. 415(c)(1)(A) covers contribution limit for solo 401k. For  tax year 2011, the maximum contribution limit is $49,000 and $50,000 for 2012.

The contribution limits apply separately to each Solo 401k participant and are made up of salary deferral and employer profit sharing contributions.

The section 415 limits are determined on a limitation year basis. The "limitation year" can be defined by the plan as any 12-month period.

Catch-up contributions can be made to Solo 401k by each participant in accordance with Treas. Reg. 1.414 (v)-1, and to qualify for catch-up contribution, the Solo 401k participant must be age 50 or older. So if you turn 50 by the end of the year, you are considered eligible to make a catch-up contribution because you are deemed to have reached age 50 as of January 1 of that year. 

SPECIAL RULE: Permitted to maximize deferrals to both 457 and 401k plans, including Solo 401k.

457 Plan is a type of retirement plan for governmental employers.

IRS Information letter 2001-0232 contains language that allows you to defer the maximum salary deferral amount [up to $17,000 for tax year 2012] to an IRC Sec. 457 plan and up to an additional $17,000 to a 401k plan, including a Solo 401k; of course, you first have to meet the Solo 401k eligibility requirements.

Effective January, 2006, Roth Solo 401k contributions may be made to 401k including Solo 401k. See Treas. Reg. 1.401(k)-1(f) of the final 401 (k) and 4019m) regulations.

When calculating profit sharing contribution amount (25% profit sharing amount), effective January 1, 2002 and after, compensation used to calculate the employer's maximum contribution [$49,00 for 2011 and $50,000 for 2012] to a plan (including a Solo 401k plan) includes salary deferrals [$16, 500 for 2011 and $17,000 for 2012].  Put simply, when calculating profit sharing contribution portion do not subtract the salary deferral [$17,000 for 2012] figure as it will reduce the allowable salary deferral limit.

The Annual Solo 401k contribution limit is not cumulative. For example, if you do not make your full annual contribution for a particular year, you cannot make it up in the following year's contribution.  Each year a participant's annual contribution is limited to the IRC 415(c) [ $49,000 for 2011 and $50,000 for 2012] limit in effect for such year.

Rollovers and transfers are not included in the annual additions/contributions category. Also, direct transfers from one retirement plan to a Solo 401k plan are not annual additions. Rollovers from IRAs (including direct rollovers) also do not fall under the annual additions category. See Treas. Reg.1.415(c)-1(b)(3)(i).

Loan repayments are not considered annual additions/contributions. Solo 401k participant Loan payments made by the participant for repayment of a participant loan are not annual additions. See Treas. Reg. 1.415(c)-1(b)(3). Reason being, the participant is paying back money that he or she borrowed from the solo 401k plan, and the amount borrowed was part of the Solo 401k account balance that you had already contributed under the section 415 limits or rolled/transferred over. You are simply repaying amounts to the Solo 401k account.

Contributions other than cash also fall under the annual additions/contributions category. A contribution of property (e.g., real estate) by the employer or Solo 401k participant is accounted for at fair market value to ascertain the amount of annual additions attributable to the contributions. See Treas. Reg. 1.415(c)-1(b)(5). However, thread carefully because if the property rules are not followed, the contribution might result in a prohibited transaction under IRC 4975. For more information, See Commissioner v. Keystone Consolidated Industries, Inc., 113 S.Ct. 2006 (1993) and DOL Reg. 2509.94-3 (Interpretive Bulletin 94-3).

IRC 404(a)(8) contains special rules for applying the deduction limits to plans (e.g., Solo 401k plan) that cover at least one self-employed individual.

IRC 401(c)(1) defines self-employed individual

IRC 401 (c)(2) defines deduction limits based on compensation of self-employed.

IRC Sec. 404 defines profit sharing deduction limits (employer contributions)

IRC Sec. 415 defines salary deferral limits (employee contributions)

IRC 401(c)(1) defines owner-employee as an employee who owns all of a business or, if a partnership, more than 10 percent of partnership or its profits.

Form 1040 Return-Reporting IRA, SEP and SIMPLE Direct-Rollover or Rollover to: Solo 401k | Self-Directed Solo 401k | Solo K | Individual 401k

After confirming that your SEP, SIMPLE or Traditional IRA direct-rollover or rollover to your new Solo 401k or Self-Directed Solo 401k has been properly reported on form 1099-R  by the releasing financial institution, the next step is to report the direct rollover/rollover deposit to IRS on your form 1040A or 1040 tax return. Note that form 1040EZ does not allow for reporting of direct-rollover/Rollover.

 

Direct Rollover vs. Rollover 

IRA, SEP, SIMPLE Direct-Rollover to Solo 401k plan or Individual 401k is only reportable but not taxable. 

 

IRA, SEP, SIMPLE Rollover to Solo 401k plan or Individual 401k is reportable but not taxable as long as funds are deposited to Solo 401k account within 60 days from date check was received (constructive receipt).  

The 1099-R you received will help you differentiate the direct rollover and rollover for proper reporting on Form 1040.

Visit following blog post to view 1099-R reporting chart: http://www.mysolo401k.net/Blog-for-MySolo401k.html?entry=2011-form-1099-r-ira

Forms needed to properly report direct rollover or rollover on your tax return:

• Form 1099-R (provided by releasing custodian financial institution usually by January 31)
• Form 1040A or 1040 (Note that form 1040EZ does not apply)

Links to Forms 1099-R, and 1040A and 1040

Form 1099-R: http://www.irs.gov/pub/irs-pdf/f1099r.pdf

Form 1040: http://www.irs.gov/pub/irs-pdf/f1040.pdf

Form 1040A: http://www.irs.gov/pub/irs-pdf/f1040a.pdf

What Form 1099-R Communicates

Direct Rollover:

• Box 1 reflects total distribution amount from your SEP, SIMPLE or Traditional IRA.
• Box 2a--the taxable amount, should read 0 for direct rollover since the check was made payable to your Solo 401k f/b/o your name as Trustee
• Box 7 contains code G--direct rollover

IMPORTANT: If any other code besides code 7 is listed in box 7, contact the releasing IRA institution right away to make the correction to code G. 

Rollover:

• Box 1 of the Form 1099-R reflects total distribution amount from your SEP, SIMPLE or Traditional IRA.
• Box 2a--the taxable amount, displays same amount displayed in box 1.
• Box 7 contains either code 1 if you were under age 59 1/2 or code 7 if you were age 59 1/2 or over in year of distribution.

SEP, SIMPLE and IRA Reporting on 1040 or 1040A

• Entire distribution goes on line 11a if you file Form 1040A, on line 15a if you use the long Form 1040.
• 0 goes in box 11b of Form 1040A or in line 15b if you file Form 1040 since you deposited funds in Solo 401k checking account. Remember to write "rollover" next to the amount.

Paying Plan Expenses: Self-Directed Solo 401k | Solo 401k | Individual 401k | Solo K

Since different expense types apply to Solo 401k (also known as Individual 401k or Solo K), including the plan's underlying investments (e.g., real estate), each expense type must be analyzed to determine whether the applicable expense  requires payment with self-employed revenue or Solo 401k funds. 

Solo 401k or Self-Directed Expenses Break Down

Identifiable costs--costs that can be anticipated in the course of plan administration and include the following:

• Plan administration
• Annual document maintenance fees
• Legal compliance
• Consulting
• Audits

     Who pays Solo 401k plan's identifiable costs?

Identifiable fees may be paid with self-employed revenue, Solo 401k plan assets or by and from both. However, if paid from Solo 401k plan assets, the expenses deplete your tax deferred funds that could otherwise have been compounding on a tax deferred basis  

Performance costs--costs that are unpredictable (i.e., not identifiable up front) such as the following:

• Additional legal costs needed to avoid plan disqualification and various penalties for noncompliance.
• Operational defects

    Who pays Solo 401k plan's performance costs?

The self-employed typically pay costs related to legal compliance with self-employment revenue.

Additional Information

ERISA's view on the use of plans assets to pay administrative expenses

ERISA expressly allows plan assets to be used to pay administrative expenses. [ ERISA 403, ERISA 404, 29 U.S.C. 1103, 1104, (1974) ] The payment of reasonable administrative expenses from plan assets is an exception to the prohibited transaction rules. [ ERISA 408 (b)(2), 29 U.S.C. 1108 (b)(2) (1974) ]

Advisory Opinion 2001-01A: This guidance contains illustrations to help clarify settler vs. plan expenses

 Can an employer reimburse a plan for expenses paid by the plan?

Reimbursement by employer/self-employed of expenses that were previously paid by Solo 401k plan will be considered an additional contribution to the plan.  [ Priv. Ltr Ruls. 9124034, 9124035, 9124036, 9124037 ]

Who pays fees/expenses in connection with Solo 401k alternative investments (e.g., real estate)?

Fees stemming from real estate investment require payment with Solo 401k funds, not personal funds.

Real estate investment expenses include:

• Property taxes
• Insurance
• Miscellaneous expenses such as HOA dues and repairs

 

2011 Form 1099-R IRA & QRP Direct Rollover & Rollover Crib Sheet: Solo 401k | Self Directed Solo 401k

Direct-Rollover Traditional/SEP/SIMPLE IRA Reporting IRA Direct-Rollover to a Solo 401k 1099-R Issued but not taxable	Rollover Traditional/SEP/SIMPLE IRA Reporting IRA Rollover to a Solo 401k 1099-R Issued but not taxable if rolled over within 60 days to Solo 401k	Transfer (Trustee-to-Trustee-Transfer) 401k, 403b, PSP, 457b No Tax Reporting Applies No 1099-R Issued
BOX 1 Gross distribution	BOX 1 Gross distribution
Reports gross direct rollover amount	Reports total value of all distributions taken for same reason during 2011. Reports all amounts withheld for federal and state income taxes.
BOX 2a Taxable amount	BOX 2a Taxable amount
Zero (-0-) is entered since distribution is payable directly to employer plan such as a Solo 401k	Same amount listed in Box 1 appears here
BOX 2b Taxable amount not determined/Total Dist	BOX 2b Taxable amount not determined/Total Dist
“Taxable amount not determined” should be checked Check box titled “Total distribution” if distribution totally depletes the IRA ,SEP, SIMPLE	“                                                        "                                                                    “                                                        "
BOX 4 Federal income tax withheld	BOX 4 Federal income tax withheld
No amount should be listed	Amount may be listed if you elected tax withholding on IRA distribution form
BOX 7 Distribution code(s)	BOX 7 Distribution code(s)
Code G –direct rollover of a distribution to a qualified plan such as a Solo 401k | Individual 401k,  should be entered	If under age 59 ½ Code 1-Early distribution If age 59 ½ or over, Code 7-Normal distribution

Plan Start-Up Tax Credit | Form 8881 DOES NOT Apply to: Solo 401k | Individual 401k | Solo K

Common misconception exists regarding the plan start-up credit which is only available to small employers. A small employer is defined as an employer that had 100 or fewer employees and who each received at least $5,000 of compensation from the employer for the preceding year. Therefore, since a Solo 401k | Individual 401k plan is for the self employed with no employees, it cannot claim the credit.

The rest of this blog posting explains the plan start-up credit but remember that it doesn't apply to Solo 401k or Individual 401k.

Resulting from the passage of the Economic Growth and Tax Relief Reconciliation Act of 2001, a qualified employer may take the tax credit for establishing a new qualified retirement plan.

Qualified start-up costs

Include any ordinary or necessary expenses incurred in connection with:

• establishment of plan;
• administration; or
• educating employees about the plan

Determining the Credit and Form 8881

• The credit equals 50% of start-up costs detailed above up to $500 per year for maximum of plan's first 3 years.

• Employer has option of applying 1^st year credit to year of plan establishment or to year before.

• To claim credit, qualified employer completes and attaches Form 8881, Credit for Small Employer Pension Plan Startup Costs, to its business tax return.

• The credit is permitted as part of employer's general business credit.

• Employer may not claim a deduction for the start-up costs in addition to claiming the credit.

• However, employer has option to elect not to claim the start-up credit at all.

Funding Methods For: Solo 401k | Self Directed 401k | Individual 401k | Solo K

In-kind transfer

An in-kind transfer entails moving the assets (non cash assets such as real estate, private investments, promissory notes, mutual funds, stocks, etc.) from a former employer or current 401k to another 401k such as a solo 401k or Individual 401k.  An in-kind transfer is preferred when you do not want to liquidate your investments but still want to transfer assets to a Solo 401k. An in-kind transfer is tax free, non tax reportable, and can be processed to Solo 401k before or after the 12/31 Solo 401k establishment deadline.

Cash transfer

Cash transfer is just what it sounds like: you move cash from your former employer 401k to a Solo 401k instead of assets (e.g., mutual funds or stocks). If your 401k is currently invested in mutual funds or stocks, you first have to contact your current 401k provider and request that they sell your mutual fund or stock positions before proceeding with cash transfer. Lastly, a cash transfer is neither taxable nor reportable to the IRS and you can process multiple cash transfers (i.e., you can move partial amounts to a Solo 401k throughout the year or the full amount at once). A cash transfer is tax free, non tax reportable, and can be processed to Solo 401k before or after the 12/31 Solo 401k establishment deadline.

In-kind direct rollover

An in-kind direct rollover differs from an in-kind transfer in that assets from an IRA not a 401k are transferred to a Solo 401k. Just like an in-kind transfer, you are moving non cash assets (e.g., mutual funds, stocks, real estate, notes, private investments, etc.) to a Solo 401k instead of liquidating the investments and then directly-rolling over cash. The movement of funds from an IRA to a Solo 401k is tax reportable but not subject to tax withholding since assets are being transferred in-kind to a Solo 401k. Lastly, an in-kind direct rollover can be processed to Solo 401k before or after the 12/31 Solo 401k establishment deadline.

60-day cash rollover 

This method of moving funds from an IRA to a Solo 401k may be the fastest of all available methods; however, it puts more pressure on you because the funds or assets are distributed to you directly and thus mailed to you. You then have 60 days from the date you receive the assets/check to deposit them to your Solo 401k in order to avoid payment of taxes and possible 10% penalty if you are under age 59 1/2. This method also subjects your IRA to tax reporting but not taxes provided the funds/assets are rolled over to your new Solo 401k timely. Lastly, the 60-day cash rollover can be processed to Solo 401k before or after the 12/31 Solo 401k establishment deadline.

NOTE: The above funding methods do not restrict you to contribution limits. Put simply, you can transfer or rollover as little or as much as you want.   

Solo 401k Funding Methods Continued

Annual cash contribution

Provided you have income from self-employment and have established your Solo 401k by 12/31 by executing the plan documents, you can fund your Solo 401k by making annual cash contribution by your tax return due date plus extensions. For tax year 2011 the maximum annual contribution limit is $49,000 for each Solo 401k participant plus an additional $5,500 per participant if age 50 or older. The maximum contribution limit for 2012 is $50,000 and the catch-up amount remains at $5,500 per participant.

Distribution Rules Applicable to: Roth Solo 401k | Roth Self-Directed 401k | Roth Solo K

In April 2007 final regulations were issued regarding taxation of distributions from what the IRS calls designated Roth accounts, commonly known as Roth Solo 401ks or Roth Self-Directed 401ks. Since the main advantage of Roth Solo 401k is tax free and penalty free withdrawals, it is important to understand the Solo 401k Roth distribution rules.  It's important to note that if distributions are made from the Roth Solo 401k prior to end of the 5 year waiting period and one of the qualifying conditions explained below, the distribution will be considered non-qualified, resulting in taxes and possible penalties of the non basis (contribution) amounts.

Qualified vs. Non-qualified Distribution from a Designated Roth Solo 401k

Qualified Distribution is:

·       A distribution from a designated Roth Solo 401k but only after 5 year waiting window has been satisfied and the participant/trustee has reached age 59 1/2, has died, or has become disabled. 

·       A distribution from a Roth Solo 401k that falls under the qualified distribution definition is not taxable to the participant/trustee.

·        A qualified Roth Solo 401k distribution maintains its basis even when funds are transferred to another Roth 401k or to a Roth IRA; therefore, they can be distributed tax and penalty free.

Illustration

After participating in her current Roth Solo 401k for 15 years, Linda decides to retire at age 63 and start making distributions from her Roth Solo 401k. Because Linda established her Roth Solo 401k over 5 years ago and she's over the age of 59 1/2, none of the distributions that she makes from her Roth Solo 401k will be subject to income tax.

Start/End of 5 year waiting period

The 5 year waiting period commences on the first day of the Solo 401k participant/trustee's taxable year, usually January 1, for which the participant/trustee first made Roth Solo 401k contribution.

The 5 year waiting period ends after 5 consecutive years have passed.

The ordering rules for non-qualified distributions from Roth IRAs do not apply to non-qualified distributions from designated Roth accounts in Solo 401k plans.

A Solo 401k Roth distribution that is not a qualified distribution (non-qualified) is subject to the pro-rata rule. This is different than the distribution rules applicable to Roth IRAs where the ordering rules apply.

A non qualified distribution from a Roth Solo 401k results in the participant/trustee including a portion of the distribution in taxable income. To determine the non-taxable amount of the distribution, the after-tax employee contributions (salary deferrals) are divided by the entire balance in the Roth Solo 401k account. The distribution amount is then multiplied by the result.

EXAMPLE

Julie has contributed salary deferrals (after-tax employee contributions) of $20,000 to her Roth Solo 401k. The total balance of her Roth Solo 401k is now $30,000, and Julie has decided to make a distribution of $9,000. Of the distribution, amount of $6,030.00 will be tax free.  

Calculated as ($20,000 / $30,000 = .67) ($9,000 X .67 = $6,030.00)

Rolling Roth Solo 401k accounts to other qualified plans or to a Roth IRA

·         Provided the receiving qualified plan permits Roth Solo 401k rollovers, existing Roth Solo 401k funds can be moved to another qualified plan such as a 401k.  Roth Solo 401k can also be rolled over to a Roth IRA. 

The amount considered rolled over is determined differently depending if the funds were moved over as a direct rollover (trustee-to-trustee transfer) or as a rollover (60- day rollover).

If processed as a Direct-Rollover, all amounts can be deposited to another Roth 401k plan or to a Roth IRA.

If processed as a Rollover (payable to the participant and rolled over within 60 days), only earnings (taxable amounts), not the basis, may be rolled over to another Roth 401k. However, the entire amount can be rolled over to a Roth IRA.