Exceptions to Early Solo 401k & IRA Distribution Tax Penalties

In addition to being subject to federal and state taxes, most IRA or solo 401k plan distributions are subject to an additional 10% tax.

Usually, the amounts an individual withdraws from a solo 401k or an IRA prior to reaching age 59½ is called ”early” or ”premature” withdrawals. Unless an exception applies, solo 401k participants and IRA holders must pay an additional 10% early withdrawal tax and report the amount to the IRS for any early distributions.

The following chart is a good guide to follow regarding the 10% early penalty when making solo 401k or IRA distributions.

The distribution will NOT be subject to the 10% additional early distribution tax in the following circumstances: Exception to 10% Additional Tax
Qualified Plans
(Solo 401(k), etc.)
IRA, SEP, SIMPLE IRA* and SARSEP Plans Internal Revenue Code Section(s)
Age
after participant/IRA owner reaches age 59½ yes yes 72(t)(2)(A)(i)
Automatic Enrollment
permissive withdrawals from a plan with auto enrollment features yes yes for SIMPLE IRAs and SARSEPs 414(w)(1)(B)
Corrective Distributions
corrective distributions (and associated earnings) of excess contributions, excess aggregate contributions and excess deferrals, made timely yes n/a 401(k)(8)(D),
401(m)(7)(A),
402(g)(2)(C)
Death
after death of the participant/IRA owner yes yes 72(t)(2)(A)(ii)
Disability
total and permanent disability of the participant/IRA owner yes yes 72(t)(2)(A)(iii)
Domestic Relations
to an alternate payee under a Qualified Domestic Relations Order yes n/a 72(t)(2)(C)
Education
qualified higher education expenses no yes 72(t)(2)(E)
Equal Payments
series of substantially equal payments yes yes 72(t)(2)(A)(iv)
ESOP
dividend pass through from an ESOP yes n/a 72(t)(2)(A)(vi)
Homebuyers
qualified first-time homebuyers, up to $10,000 no yes 72(t)(2)(F)
Levy
because of an IRS levy of the plan yes yes 72(t)(2)(A)(vii)
Medical
amount of unreimbursed medical expenses (>7.5% AGI; after 2012, 10% if under age 65) yes yes 72(t)(2)(B)
health insurance premiums paid while unemployed no yes 72(t)(2)(D)
Military
certain distributions to qualified military reservists called to active duty yes yes 72(t)(2)(G)
Returned IRA Contributions
if withdrawn by extended due date of return n/a yes 408(d)(4)
earnings on these returned contributions n/a no 408(d)(4)
Rollovers
in-plan Roth rollovers or eligible distributions contributed to another retirement plan or IRA within 60 days yes yes 402(c), 402A(d)(3), 403(a)(4), 403(b)(8), 408(d)(3), 408A(d)(3)
Separation from Service
the employee separates from service during or after the year the employee reaches age 55 (age 50 for public safety employees in a governmental defined benefit plan) yes no 72(t)(2)(A)(v),
72(t)(10)

NOTE: Governmental 457(b) distributions are not subject to the 10% additional tax except for distributions attributable to rollovers from another type of plan or IRA.

The penalty is 25% instead of 10% for a  SIMPLE IRA if made within the first 2 years of participation

Bad Credit Business Funding Option – Use Your 401k to Start a Business

Are you an aspiring entrepreneur with bad credit? In that case you know well that financing a business with bad credit is no easy task.

Even for a small business owner with good credit, access to financing from traditional sources such as banks, credit unions can be challenging.  According to the Harvard Business School “The State of Small Business Lending” report, the credit market has not returned to pre-crisis levels and has been markedly  more constrained for the small business segment. [1]

For an aspiring business owner with bad credit, the options are even more limited and those lending options that are available are expensive.  For example, an individual with bad credit (typically defined as a credit score below 630) could easily pay 20% or more for a business loan from an alternative lender or finance company.

Other than taking on a loan with credit card-level interest rates, other sources that are typically considered are borrowing money from friends or relatives or perhaps seeking a grant.

Even if these options might be possible, they are less than ideal.  An aspiring entrepreneur will want to avoid the financial pressure of paying back a high-interest loan or the social pressure of being in debt to friends or relatives.  Even if a grant may be possible, the entrepreneur may not have the time to apply for a grant that ultimately may not be awarded.

There is another way to acquire the small business financing you need.  This alternative does not require a credit check nor is it a loan that needs to be paid back.  The strategy entails investing your retirement funds in your own business and is referred to as a rollover as business startup (ROBS) or 401k Business Financing.  If properly structured and executed, you can access all of your retirement funds without paying taxes or penalties.

The high-level steps of a ROBS transaction are as follows:

  • The first step is to form a corporation which must be taxed as a C-corporation.
  • The corporation then adopts a 401k profit sharing plan.
  • As an employee of the corporation, you would participate in the 401k plan and then transfer your retirement funds from your existing retirement account (e.g., former employer 401k, Rollover IRA, etc.)  into the 401k plan.
  • You would then invest your 401k funds in company stock by transferring funds from the 401k to the corporation.
  • The corporation would then be able to use the funds for legitimate business purposes (e.g., buy the assets of an existing business, start a new franchise, etc.).

There are important ongoing compliance requirements (e.g., annual reporting, offering employees the 401k, etc.) as well as specific issues that have to be considered on a case-by-case basis (e.g., whether funds in your existing retirement account are eligible, etc.).

To learn more about how to start or buy a business or franchise with your retirement funds, please visit our 401k small business financing page and the related links.

To learn more about how our 401k Business Financing plan would work for you please call us at 800.489.7571.

Notes:

  1. Mills, Karen, and Brayden McCarthy. “The State of Small Business Lending: Credit Access during the Recovery and How Technology May Change the Game.” Harvard Business School General Management Unit Working Paper 15-004 (2014). http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2470523

2015 Scholarship Winner Announced

401k Business Financing Scholarship Winner (Anthony Lena)My Solo 401k Financial is thrilled to announce Anthony Lena (pictured) as the recipient of its 2015 college scholarship award.  Anthony’s essay on “What are the benefits of using funds in your 401k, IRA or other retirement account to finance your business or franchise?” was chosen from nearly 100 applicants.   Anthony is a Master Chief Operator (Naval Special Warfare) and is pursuing his Master’s degree in the Global Master of Arts Program in the Fletcher School at Tufts University.  My Solo 401k Financial is proud to support Anthony in his educational endeavors and wishes him great success in his academic and professional pursuits.

FedEx Route Financing: 401k Business Client Delivers Success with Independent FedEx Route

Our 401k Business Financing Client David Obal has found quick success with his independent FedEx route business.  David used his 401k funds to leave his successful career in logistics at a Fortune 500 company to acquire two FedEx routes in Arizona.  Within 2 short years, his business has grown to allow him to acquire three more routes.  While he had some healthy fear in taking the “leap of faith” to start his own business, the decision to do so has allowed David to get more out of life, career and time with his family.  To read more about the success that David achieved by using our 401k Business Financing plan please download the report from Sierra Vista Herald/Bisbee Daily Review here (4.77MB).

Seller Financing / Seller Carry Back

Q: Where do I book/record seller financing (seller carry back) for my 401k business financing corporation transaction?

A: A seller carry back is not a stock/equity purchase but rather financing that the seller is providing to the ROBS 401k funded C-Corporation.  As such, this transaction is documented between the corporation and the seller as a loan.  It would be reflected on the Corporation’s book as a debt obligation rather than a stock/equity investment.  As such, no stock certificates are issued in connection with seller financing.

Learn More

401k Business Financing FAQs

Videos

2015 COLA Limits

The IRS has released the cost-of-living adjustments (COLA) applicable to the dollar limitations for qualified plans (and other items) for the 2015 tax year. The regulations places limits on the contributions to 401k plans and IRAs. These limits are adjusted annually for cost-of-living increases.

IRS Limits 2015 2014
401(k) deferrals/catch-up $18,000/$6,000 $17,500/$5,500
Compensation defining highly compensated employee $120,000 $115,000
Compensation defining key employee/officer $170,000 $170,000
Defined contribution plan limit on annual additions $53,000 $52,000
Maximum compensation limit for allocation and accrual purposes $265,000 $260,000
IRA contributions/catch-up $5,500/$1,000 $5,500/$1,000

 

Key Employees Defined for top heavy testing

Pursuant to IRC 415(i)(1), a key employee is any employee who, during the preceding plan year (exception for first plan year, use the current year):

  • was a more than 5% owner of the employer;
  • was a 1% owner of the employer having an annual compensation of more than $150,000; or
  • was an officer or the employer and received compensation greater than $170,000.

With respect to the 5% and 1% ownership tests, certain attribution rules apply with regard to family members, certain trusts or other entities.

There are limitations on how many officers may be considered key employees, as illustrated in the following chart:

 

Number of Employees Maximum Number That May Be Considered Officers
1-30 No more than 3
31-499 10% of actual number of employees
500 or more No more than 50

Highly Compensated Employees Defined for ADP/ACP Testing

Pursuant to IRC 414(q), a highly compensated employee (HCE) is any employee who:

  • was more than 5% owner of the employer during 2015 or 2014; or
  • received compensation from the employer in excess of $115,000 for 2014. (The employer may elect to limit the number of employees in this category to those who are in the top 20% of employees for 2014).

Compensation for defining HCE’s is all compensation actually received, plus amounts deferred because of a 401)k) plan, cafeteria plan or tax sheltered annuity plan. It includes all salaries, fees, commissions, bonuses and tips, even though the plan’s definition may not include these for purposes of allocating the employer contributions. The compensation used for ADP testing, however, may exclude 401(k) plan deferrals and cafeteria salary deferrals if the 401(k) plan so provides. Compensation in the 401(k) plan may be excluded for testing purposes.

The 401(k) salary deferral limit for 2015 is $18,000.

Compensation greater than $265,000 for 2015 will not be considered for all plan purposes.

Click here to learn about Key Employees for top heavy testing.

Roth IRA Conversion Rules

Owner must pay taxes on pretax amounts converted

When converting IRA assets to a Roth IRA, the IRA owner must pay tax on all pretax (deductible) assets. Although the assets are taxed, they are not subject to the 10 percent early distribution penalty tax if properly converted into a Roth IRA.

IRA owners must include all pretax assets that are converted to Roth IRAs in their taxable income (but no 10 percent early distribution penalty tax) (IRC Sec. 408A(d)(3)(A)(i) and (ii)).

Form 1099R and Form 5498 Reporting Applies

An IRA distribution that is directly converted to a Roth IRA is reported on Form 1099-R, Box 7, using distribution code 2, Early distribution, exception applies (for IRA owners under age 591⁄2), or code 7, Normal distribution (for IRA owners age 591⁄2 and older). A financial organization that receives a direct conversion reports the amount as a conversion contribution in Box 3 of Form 5498. The 60-day and one-per-12-month rollover restrictions do not apply.

The distributing IRA financial organization must send Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., to the IRS and the individual receiving the distribution.

Form 1099-R generally must be submitted to the IRA owner by January 31 and to the IRS by February 28 if filing on paper, or March 31 if filing electronically.

Conversions Included in Income

An individual generally must include in taxable income in the year the converted assets are distributed from the Traditional IRA any amounts consisting of pretax contributions (salary deferrals, employer contributions, or deductible IRA contributions).

EXAMPLE: Barb has a Traditional IRA to which she has made only deductible IRA contributions. In 2015, Barb decides to convert her Traditional IRA to a Roth IRA. The taxable amount of the Traditional IRA assets converted is $30,000. Barb will include $30,000 in income in 2015.

Conversion of Property

When individuals receive property (such as shares of stock) as part of a Traditional IRA distribution to convert to a Roth IRA, that same property must be converted. The financial organization must be able to take legal title to the property.

Reporting the conversion on your personal tax return

Report the taxable part of the distribution on lines 15a and 15b of Form 1040.

File Form 1099R, which is provided by the IRA custodian, with your 1040.

Year 2015 Table for qualifying for Roth IRA Contributions

This table shows whether your contribution to a Roth IRA is affected by the amount of your  modified AGI as computed for Roth IRA purpose.

If your filing status is… And your modified AGI is… Then you can contribute…
married filing jointly or qualifying widow(er)

 < $183,000

 up to the limit

 > $183,000 but < $193,000

 a reduced amount

 >  $193,000

 zero
married filing separately and you lived with your spouse at any time during the year

 < $10,000

 a reduced amount

 > $10,000

 zero
single, head of household, or married filing separately and you did not live with your spouse at any time during the year

 < $116,000

 up to the limit

 > $116,000 but < $131,000

 a reduced amount

 > $131,000

 zero

 

For 2015, your total contributions to all of your traditional and Roth IRAs cannot be more than:

  • $5,500 ($6,500 if you are age 50 or older), or
  • your taxable compensation for the year, if your compensation was less than this dollar limit.

The IRA contribution limit does not apply to Rollover contributions.

Additional resources

  • About MySolo401k

    We help our clients take control of their retirement money. Our products and services provide our clients the freedom to invest their retirement savings in their own business as wells as alternative investments such as real estate, private companies, promissory notes, precious metals, tax liens and equities.
    Learn more

    Connect with us

  • We’re here to help.

    Call: 800-489-7571

    Monday-Saturday

    7:30 am - 5:30 pm PT

    Why us?