When to Close a Solo 401k Account: Rules and Steps to Stay Compliant

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Understanding When to Close a Solo 401k

Solo 401k plans are powerful tools for self-employed individuals and entrepreneurs. They allow you to save for retirement while taking advantage of flexible contribution limits and tax benefits. But these plans come with specific rules that determine when they need to be closed.

Certain events, like ending your self-employment or hiring employees, can make your Solo 401k ineligible. Knowing when and how to close your plan is essential to stay compliant with IRS regulations. Failing to follow these rules could lead to penalties, unnecessary taxes, or other complications.

What triggers the need to close a Solo 401k?

Sometimes, life or business changes mean it’s time to close your Solo 401k. Understanding the triggers can help you act quickly and avoid penalties. Here are the key scenarios that require closing your plan.

1. Ending Self-Employment

Did you permanently stop self-employment? This is when to close a Solo 401k. If you shut down your business entirely or transitioned to work that doesn’t qualify as self-employment, you’ll need to switch plans or close the account.

If you plan to start another business, you may be able to update your Solo 401k for the new activity instead of closing it. But if self-employment is permanently over, the plan must be terminated.

2. Hiring Full-Time Employees

Solo 401ks are designed for owner-only businesses. Hiring full-time employees makes your business ineligible to maintain this type of plan. Full-time employees are defined as those working 1,000 hours or more in a year.

When you hire a full-time employee, your Solo 401k must be closed. You’ll need to transfer the assets to an IRA or convert the plan into a traditional 401k. This ensures compliance with IRS rules.

3. Employing Long-Term Part-Time Employees

Even part-time employees can affect your Solo 401k eligibility. The IRS requires you to include long-term, part-time employees if they work 500 hours or more in two consecutive years.

Once a part-time employee meets this threshold, you must take action. Since Solo 401ks don’t allow employee participation, you’ll need to either close the plan or convert it to a traditional 401k that includes employee benefits.

The first step is determining when your employee becomes eligible. After that, you’ll follow the steps to close the plan, transfer assets, and file the necessary IRS forms. Waiting too long to comply could trigger penalties and audits.

Can I keep a Solo 401k if my business becomes dormant?

A dormant business isn’t actively generating income but hasn’t been formally shut down. The IRS allows you to keep a Solo 401k open in these cases, but there are conditions.

If your business is dormant, you can freeze your Solo 401k. This means you stop making contributions and can’t take new loans from the account. The plan stays open, but it’s essentially on pause until your business becomes active again.

During the freeze, you’ll still need to maintain the plan’s administrative requirements. That includes filing any necessary IRS forms and ensuring the plan remains compliant with regulations. If you eventually decide to close the business for good, the Solo 401k must also be terminated.

Steps for Closing a Solo 401k

Closing a Solo 401k isn’t complicated, but you must follow the proper steps to stay compliant. Here’s what you need to do:

1. Filing Required IRS Forms

Start by handling the paperwork. You’ll need to file a final Form 5500-EZ to report the plan’s closure. Even if your plan’s value is under $250,000, this form is mandatory when closing the plan.

Next, issue a 1099-R to report the rollover of assets. This form tells the IRS where the funds are going and ensures they’re being transferred to a qualified account without triggering taxes or penalties.

2. Transferring Assets

Once the forms are in order, it’s time to move your money. Most people roll their Solo 401k funds into a traditional or Roth IRA. This keeps the tax advantages intact and ensures your savings stay protected.

If your Solo 401k includes alternative investments like real estate or cryptocurrency, transferring can be trickier. You’ll need a self-directed IRA to accommodate these assets. Be prepared for additional paperwork and fees to handle the transfer properly.

3. Finalizing the Closure with Your Provider

Your Solo 401k provider will have specific steps for terminating the plan. Contact them to understand their requirements, which may include additional forms or fees.

Make sure to double-check that everything is finalized. Once the plan is closed, keep copies of all forms and documents for your records. This ensures you’re fully covered if the IRS ever has questions.

What happens if I don’t close a Solo 401k when required?

If you don’t close your Solo 401k when required, the IRS may come knocking. They expect plans tied to inactive businesses to be closed by the end of the following year.

Failing to close the plan can lead to penalties. You could face fines for non-compliance, and any improper use of the account might trigger additional taxes or audits. It’s not a risk worth taking.

Compliance is non-negotiable. Closing your Solo 401k on time keeps your retirement savings safe and your financial life free of unnecessary headaches. If in doubt, consult a professional to make sure everything is handled correctly.

What are my options for transferring assets when closing a Solo 401k?

When you close a Solo 401k, you’ll need to transfer its assets to another qualified retirement account. The method you choose depends on the types of investments held in the plan. Here are your main options:

1. Traditional IRA Transfers

If your Solo 401k holds cash, stocks, bonds, or mutual funds, rolling the assets into a traditional IRA is the most straightforward option. This allows you to maintain the tax-deferred status of your retirement savings and avoid triggering taxable events.

Make sure the rollover is done as a direct transfer. If the funds pass through your personal accounts, the IRS may treat it as a distribution, which could lead to taxes and penalties.

2. Self-Directed IRA Transfers

For Solo 401ks with alternative investments like real estate, private equity, or cryptocurrency, a self-directed IRA is often the best choice. This type of account allows you to continue holding non-traditional assets while keeping the tax benefits of retirement savings.

Transferring alternative investments can be complex. Real estate, for example, requires retitling the property under the new IRA custodian. Be sure to work with a provider experienced in handling self-directed IRA rollovers to avoid mistakes.

3. Tax Reporting Requirements

Regardless of the type of transfer, proper tax reporting is essential. You’ll need to file a 1099-R to document the transfer and ensure it’s classified as a rollover rather than a taxable distribution. Always consult with your plan provider or a tax professional to ensure all forms are completed accurately and on time.

Failing to handle the transfer correctly can result in unexpected taxes, penalties, and headaches down the road. Take the time to get it right.

Can I convert a Solo 401k to another plan?

Sometimes closing a Solo 401k isn’t your only option. Depending on your circumstances, you may be able to convert the plan instead of shutting it down entirely. Here’s how:

Converting to a Traditional 401k

If your self-employed business grows and you hire full-time employees, converting your Solo 401k to a traditional 401k plan might be the next logical step. Traditional 401k plans accommodate employee contributions and comply with IRS rules for larger businesses.

To make the switch, you’ll need to restate the Solo 401k under a new plan document that supports employees. This includes updating plan terms to meet IRS non-discrimination testing requirements. Your plan provider should guide you through the process, but it’s worth noting that this option typically involves higher administrative costs and additional responsibilities.

While more complex, this transition allows you to retain the retirement savings infrastructure you’ve built while scaling your business.

Switching to a New Business

If you plan to start another self-employed venture, you can often update your Solo 401k to reflect the new business rather than closing it entirely. This is especially useful if you want to keep the same investments and account structure.

To make the switch, the Solo 401k must be amended to list the new business as the sponsoring entity. You’ll need to ensure the new business qualifies as self-employment for IRS purposes. Keep in mind that if the business becomes inactive again, you’ll need to revisit the decision to close or convert the plan.

Converting your Solo 401k to align with a new business venture offers flexibility and keeps your retirement savings intact without unnecessary disruptions. Contact Nabers Group, we can help out with this transition, and ensure the switch goes smoothly.

How and When to Close a Solo 401k Due to Retirement

Retirement often signals the natural endpoint for a Solo 401k plan. When you retire, you’ll need to decide how to handle the funds in your account and complete the closure process.

Rolling Over Funds to an IRA or Taking Distributions

You have two main options when closing your Solo 401k in retirement: rolling the funds into an IRA or taking distributions. Rolling funds into an IRA allows you to maintain tax-deferred growth while simplifying account management. This is especially useful if you want more investment options or prefer a single account for retirement savings.

If you choose to take distributions, these will be taxed as income unless they’re from a Roth Solo 401k. Be mindful of your tax bracket and consider spreading distributions over several years to minimize your tax burden.

Planning for Required Minimum Distributions (RMDs)

Once you reach the age of 75 (or 73 if born before 1960), RMDs are mandatory for traditional Solo 401k accounts. Failure to take RMDs on time can result in a 25% penalty on the amount you were supposed to withdraw.

To plan effectively, calculate your RMDs based on your account balance and the IRS distribution period. You can also use RMDs as an opportunity to strategically withdraw funds to cover living expenses while staying compliant with IRS rules.

Final Steps to Close the Plan After Retirement

After rolling over funds or taking distributions, this is when to close a Solo 401k plan. This involves filing a Form 5500-EZ for final reporting and issuing a 1099-R to document any rollovers or distributions. Work with your plan provider to ensure all paperwork is completed accurately and submitted on time.

Closing the plan properly avoids IRS penalties and ensures a smooth transition for your retirement funds.

Conclusion

Knowing when to close a Solo 401k isn’t complicated, but it does require attention to detail. Whether it’s hiring employees, retiring, or ceasing self-employment, understanding when to close a Solo 401k ensures you stay compliant with IRS rules.

Taking the proper steps—like transferring assets and filing required forms—protects your savings and avoids unnecessary penalties.

FAQs About When to Close a Solo 401k

What happens to a Solo 401k if I hire employees?

If you hire full-time employees who work over 1,000 hours a year, your Solo 401k becomes ineligible. You’ll need to convert it to a traditional 401k or close the plan entirely by transferring the funds to another qualified account.

How do I transfer investments when closing a Solo 401k?

You can roll over traditional investments like stocks and bonds into a standard IRA. Alternative investments, such as real estate or cryptocurrency, should be transferred to a self-directed IRA. Always work with your provider to avoid triggering taxable events.

Can a dormant business maintain a Solo 401k?

Yes, if your business is dormant but legally active, you can freeze your Solo 401k instead of closing it. However, during a freeze, you cannot make new contributions or take loans from the plan. If you permanently cease self-employment, the Solo 401k must be terminated and its assets transferred.

What forms are required to close a Solo 401k?

To close a Solo 401k, you must file a Form 5500-EZ for final reporting and issue a 1099-R to document any rollovers or distributions.

One Response

  1. #1. What if my funds are in a Solo 401K Roth IRA checking account? I have never moved them out or invested them because I didn’t know how to do it. When you move them out, is that considered a DISTRIBUTION to get the funds out or is it a ROLLOVER? I have a traditional IRA and a Roth IRA at Schwab already setup. Isn’t there a timing requirement to move funds out of a solo Roth IRA account? I believe 5 years from the date of your first contribution to roll them out to another Roth without any penalty or taxable event? If it has not been 5 years do I have to hold the solo plan open until the 5 years are up? OR #2. what if I to keep the solo plan alive, can I switch the provider from my C Corp (W2 income) to me personally as a consultant that receives 1099 NEC income? What is the process to switch it to my 1099 income? Who would the sponsor be for example? myself? Is there a process I need to follow to make that change?

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