How to Properly Close Your Solo 401k: A Step-by-Step Guide

A Solo 401k is a powerful retirement savings tool for self-employed individuals and small business owners with no full-time employees. However, there may come a time when you need to close your Solo 401k account. 

Common reasons for closing include retirement, selling your business, hiring employees, or even switching to a different retirement plan. Understanding when and why to close your Solo 401k is crucial for avoiding tax penalties and ensuring you follow proper legal procedures.

If you’re at the point where you’re considering this step, it’s essential to handle the closure properly. Failing to do so could lead to unnecessary tax liabilities and fines. We’ll guide you through the process of how to close your Solo 401k smoothly, discussing what you’ll need to prepare and the IRS filing requirements.

Assessing Your Current Situation Before Closing

Before taking steps to close your Solo 401k, it’s important to assess your financial and retirement situation to be sure it’s the right move for you. Are you retiring, closing your business, or transitioning to a new retirement plan? Your reasons for closing can influence how you handle the process.

First, check your account balance and review your tax status. Make certain all contributions are current, and no further contributions are being made before starting the closure process. In some cases, business owners may choose to close their Solo 401k when moving on to a traditional 401k plan or setting up a new retirement vehicle due to business changes.

It’s essential to evaluate the long-term tax implications and confirm that you won’t miss out on other options like rollovers or conversions that can keep your savings tax-advantaged.

Preparing to Close Your Solo 401k

Once you’ve assessed your situation, it’s time to prepare the necessary steps to close your Solo 401k. Here are the key steps:

1. Notify Your Plan Provider: The first step in the process is to notify your account provider about your intent to close your solo 401k plan. They will provide you with specific instructions, forms, and timelines to begin the termination process.
2. Review IRS Requirements: Closing a Solo 401k isn’t just about withdrawing the funds or moving them to another account. There are specific IRS requirements that you must follow to avoid tax penalties. It’s essential to understand these before proceeding.
3. Verify Loan Repayments: If you have taken any loans from your Solo 401k, they must be fully repaid before you can close the account. Any outstanding loans may result in additional taxes and penalties if not addressed properly.

Closing a retirement account involves various steps, and working with your provider and tax professionals will ensure you meet all requirements for closing your Solo 401k while avoiding costly mistakes.

IRS Filing Requirements: Form 5500-EZ

The IRS requires you to file Form 5500-EZ when closing your Solo 401k, which is critical for keeping everything compliant. Here’s what you need to know:

• When and Why to File: Form 5500-EZ must be filed if your Solo 401k plan has assets of $250,000 or more at the time of closure, or if the plan is being terminated regardless of the balance. This form reports the details of your plan’s termination and keeps you compliant with IRS regulations.
• Who Is Required to File: If you’re closing your Solo 401k, you may be required to file either Form 5500-EZ or Form 5500-SF (for certain smaller plans). Failing to file the required form can result in penalties or other IRS actions.
• How to File Form 5500-EZ: Filling out Form 5500-EZ requires you to provide detailed information about your plan, including contributions, distributions, and the account balance. It’s vital to submit this form on time to skip complications.
• Form 5500-SF: If you have a smaller plan or meet specific criteria, filing Form 5500-SF may be an option. This form offers a simplified filing process for plans with fewer administrative requirements.

Ensuring you file the correct form is essential to avoid penalties and to close your Solo 401k properly.

Options for Handling Your Solo 401k Funds

When closing your Solo 401k, you’ll need to decide what to do with the funds in your account. Here are three key options to consider:

1. Rolling Over to Another Retirement Plan

One of the best ways to avoid triggering taxes is by rolling over your Solo 401k funds into an IRA or another qualified 401k plan. This is known as a direct rollover and helps ensure you don’t face tax penalties. You’ll want to confirm that the new plan allows the same flexibility for investments and contributions as your Solo 401k.

2. Cashing Out

If you choose to cash out the account, be aware that this decision will result in immediate tax implications. The funds will be treated as ordinary income, and if you’re under the age of 59 ½, you may also face a 10% early withdrawal penalty. Cashing out might seem appealing, but the tax burden could significantly reduce the amount you keep.

3. Roth Conversions

If you’re interested in converting to a Roth IRA, now might be the time to consider it. Converting to a Roth IRA allows your retirement savings to grow tax-free, and future withdrawals are not taxed. However, keep in mind that you’ll need to pay taxes on the amount you convert at the time of the conversion, so it’s important to calculate if this move is financially beneficial in your situation.

Tax Implications of Closing a Solo 401k

The tax consequences of closing your Solo 401k depend on how you handle the funds. Here’s a breakdown of what to expect:

• Cashing Out and Its Impact on Your Taxable Income: Cashing out your Solo 401k will result in the entire balance being added to your taxable income for the year. If you’re in a higher tax bracket, this could mean a significant tax liability. Additionally, the amount withdrawn will be taxed at your ordinary income tax rate.
• Early Withdrawal Penalties: If you are under 59 ½ years old, cashing out your Solo 401k will not only increase your taxable income but also subject you to a 10% early withdrawal penalty. This penalty can significantly diminish the amount of money you receive from your account.
• Rollover Strategies to Minimize Taxes: The most tax-efficient way to close your Solo 401k is to do a direct rollover into an IRA or another 401k plan. By moving your funds into a tax-advantaged account, you can delay taxes until you begin making withdrawals in retirement. If you choose a Roth IRA rollover, you’ll pay taxes at the time of the rollover but benefit from tax-free growth and withdrawals later.

Common Mistakes to Avoid When Closing a Solo 401k

Closing a Solo 401k involves many steps, and mistakes can lead to costly tax liabilities or penalties. Here are some common errors to steer clear of:

• Failing to Notify the IRS and Your Provider: One of the biggest mistakes is neglecting to inform the IRS and your Solo 401k provider about your plan’s closure. The IRS requires specific forms to be filed when terminating a retirement plan, and missing these deadlines could result in penalties.
• Improper Fund Handling: Directly cashing out your Solo 401k without understanding the tax implications can lead to unexpected taxes. Always explore options like rollovers before opting for a lump-sum withdrawal. Make sure you follow IRS guidelines closely to avoid any unnecessary tax burdens.
• Neglecting Loan Balances: If you have an outstanding loan on your Solo 401k, you’ll need to repay it before closing the plan. Failing to repay the loan will result in the outstanding balance being considered a taxable distribution, which could lead to additional taxes and penalties.

Special Considerations for Businesses Closing or Restructuring

When closing or restructuring a business, special considerations must be made for your Solo 401k plan. Here’s what you need to keep in mind:

Business Closure

If you’re closing your business entirely, you’ll likely need to close your Solo 401k plan as well. In this case, you’ll need to follow the proper steps outlined above, including filing the necessary forms with the IRS and notifying your provider. Depending on your future plans, you might choose to roll the funds into an IRA or another retirement plan.

Business Restructuring

If you’re restructuring but continuing operations, you may not need to close your Solo 401k. However, changes in your business structure could impact your ability to maintain the plan, especially if you hire full-time employees. In such cases, transitioning to a different retirement plan, such as a traditional 401k, may be necessary.

Merging with Another Business

If your business is merging with another, the situation may become more complex. Depending on the structure of the merged entity, you may have to roll over your Solo 401k into a new plan or explore other retirement savings options that accommodate a larger workforce. It’s essential to review the retirement options available post-merger to ensure your funds remain tax-advantaged.

Closing Your Solo 401k Due to Hiring Employees

One of the key reasons for closing a Solo 401k is when your business grows to include W-2 employees. Here’s what you need to know:

Transitioning to a Traditional 401k Plan

If you hire employees, the IRS requires you to transition from a Solo 401k to a traditional 401k or another employer-sponsored plan. Solo 401k plans are only for businesses without full-time employees (other than you or your spouse), and the presence of other employees will disqualify you from maintaining the Solo 401k structure.

Impact of Hiring W-2 Employees

Hiring W-2 employees triggers the need to convert your Solo 401k into a multi-participant 401k plan. This transition guarantees that your employees can also participate in the retirement savings plan. While this brings additional administrative tasks and potential costs, offering a traditional 401k can make your business more competitive in terms of benefits.

Steps to Transition

To smoothly transition from a Solo 401k to a traditional 401k, follow these steps:

1. Work with a financial advisor or plan administrator to establish a new multi-participant 401k plan.
2. Rollover existing Solo 401k funds into the new 401k plan to consolidate retirement savings.
3. File the necessary paperwork with the IRS, including terminating the Solo 401k plan and initiating the new plan.

By carefully transitioning your retirement plan, you can accommodate your growing workforce while ensuring compliance with IRS regulations.

Frequently Asked Questions

Can I Keep My Solo 401k if I No Longer Have Self-Employment Income?

No, to maintain a Solo 401k, you need to have ongoing self-employment income. If you no longer earn self-employment income, you’ll need to either roll over the funds into an IRA or another 401k plan or cash out the account.

What Happens If I Don’t File Form 5500-EZ When Closing the Plan?

Failure to file Form 5500-EZ when required can result in significant IRS penalties. It’s important to file this form to officially terminate your Solo 401k and remain compliant with IRS regulations.

How Long Do I Have to Roll Over My Funds After Closing a Solo 401k?

You generally have 60 days to roll over funds from a Solo 401k into another retirement plan or IRA to prevent tax penalties. Direct rollovers are preferred, as they help avoid any tax withholdings.

What Are the Differences Between Closing a Solo 401k and a Traditional 401k?

The main difference lies in the complexity of the process. Solo 401k plans are easier to close due to fewer participants and simpler management. Traditional 401k plans involve more participants, additional reporting, and more stringent IRS guidelines.