Delaying the Mandatory 20% Federal Tax By Processing a Direct Rollover to an IRA
A question regarding Solo 401K distributions, and maybe a way to avoid the 20% withheld Federal tax…
Does the Solo 401K allow for a direct rollover to another IRA, with subsequent withdrawal from that IRA, such that the 20% Federal tax withholding can be mitigated?
Yes it is true the mandatory federal income tax withholding of 20% that applies to distributions from 401k plans including solo 401k plans can be delayed until your personal tax return due date by directly rolling over the solo 401k funds to an IRA. However, the solo 401k participant still has to satisfy a triggering event
even if the plans is to directly rollover the funds to an IRA.
Here are the solo 401k triggering events:
Types of Solo 401k Contributions and Distribution Rules
- After-Tax Contributions and Rollover Contributions. The solo 401k plan participant may withdraw at any time (after completing a distribution form), all or any portion of her account balance attributable to “rollover contributions” and/or “after-tax contributions.”
- Employer Contributions: Employer contributions are subject to more stringent distribution rules and may be distributed upon the solo 401k participant’s severance from employment, death, or disability. In addition, employer contributions may be withdrawn upon the occurrence of any of the following events:
1) The occurrence of a Hardship,
2) The attainment of age 59 ½
3) The employer contributions being withdrawn have been accumulated in the solo 401k plan for at least 2 years; or
4) The participant has participated in the solo 401k plan for at least 5 years.
- Salary Deferrals (employee contributions): Any employee contribution (including any earnings on such amounts) may not be distributed prior to the solo 401k participant’s severance from employment, death, or disability. However, the solo 401k plan permits an in-service distribution of such amounts upon attainment of age 59 ½ or upon a Hardship.
Delay the Payment of Federal Taxes–Cannot Avoid the Taxes
It is also important to note that even though you may satisfy one of the above distribution triggering events, which would allow you to directly rollover some or all of the solo 401k funds to an IRA, for the purpose of subsequently processing the distribution from the IRA and the 20% mandatory federal tax withholding would not apply at the time of the IRA distribution, the federal tax payment can only be delayed not avoided. Instead of paying the mandatory tax upfront if the funds were distributed from the solo 401k plan, you are simply delaying paying the federal tax until your file your personal tax return following the year of the IRA distribution. For more information surrounding the federal tax withholding requirements and payments from retirement accounts, visit Publication 575
Lastly, if you meet one of the above solo 401k distribution triggering events, and whether or not you decide to proceed with taking the distribution from the solo 401k or directly rolling the funds to an IRA, a distribution
form will need to be filled out and a Form 1099-R will need to be issued under either case so make sure to coordinate the transaction with your solo 401k plan provider
such as My Solo 401k Financial.