Investing in a Solo 401k and Converting Before Age 59 1/2

[Truthseeker]

Background:
I am an independent contractor who will receive about $100k in 1099 income in 2016. We live completely off my wife's income so I am trying to put as much of that money into a tax deferred account as possible to minimize taxes. After doing some research, it looks like the solo 401k is my best bet. While I might establish an LLC next year to increase the amount I can contribute to the Solo 401k, this year I'll be establishing the account as a sole proprietor. My wife and I currently have retirement accounts with Vanguard and Fidelity.

Question(s):
I called Fidelity and they told me I couldn't withdraw or convert any of the Solo 401k funds until a "life event" at the age of 59 1/2. They said this was a Fidelity and Vanguard policy, not an IRS policy. My goal is to retire long before then and convert those funds to Roth IRA using five year ladder approach (still learning the details of this). Has anyone else encountered this? Could I just start with Fidelity (since they offer ETFs, individual stocks, and no fees unlike Vanguard) and then just transfer the funds later somewhere else where I'll be allowed to convert the funds? Are there some plan administrators who charge low or no fees that would allow me to convert the solo 401k to a Roth?

[bacchi]

You can contribute 20% profit sharing as a sole proprietor. You don't have to manage your own LLC to contribute more...but Vanguard/Fidelity may require an LLC in order to open a solo 401k

I haven't done this but I probably will next year -- a "life event" might be dissolution of your company. You'll then do a rollover as anyone normally does when they change employment.


Eta: The usual flow is 401k-> tIRA-> rIRA.

[nereo]

posting to follow...

[Djeayzonne]

I just went through this with them as well and just opened my solo 401k with them a few weeks ago.

You aren't going to be able to contribute anymore as a LLC. The profit sharing continuation itself is an expense in your schedule C, so it 25% of your net. If your net before the contribution was 100k, then 20k contribution (25% of 80k).

You can actually find a list of qualifying events, one of which is simply ending the business, which is exactly what you will do when you retire. I talked to at least three different of their retirement specialists to confirm this.

[Truthseeker]

I just went through this with them as well and just opened my solo 401k with them a few weeks ago.

You aren't going to be able to contribute anymore as a LLC. The profit sharing continuation itself is an expense in your schedule C, so it 25% of your net. If your net before the contribution was 100k, then 20k contribution (25% of 80k).

You can actually find a list of qualifying events, one of which is simply ending the business, which is exactly what you will do when you retire. I talked to at least three different of their retirement specialists to confirm this.

Thanks so much for your help. I just wanted to clarify two things you said:

1. Ending my business, as a sole proprietor, would that just mean I no longer make 1099 income? I don't ever anticipate "retiring" in the traditional sense where I don't have at least some side activities that may generate income. With an entity like an LLC, you would just close out the LLC, but I wasn't sure how that worked as far as official "start" and "end" of my business when the business is me. Does that make sense? Do you know how that's done or indicated as a sole proprietor for Fidelity purposes?

2. Could you explain a little more about the LLC vs. sole proprietor for solo 401k? My understanding is that sole proprietor employer contribution is net earnings ($100k) in this case minus 1/2 of the self-employment tax ($7064) * 20% giving me $18,587 for the employer contribution in addition to my $18,000 employee contribution. However, when I plug in the same $100k into some of these online calculators and select a corporation, I get a straight $25,000 (25% of the 100k) for employer contribution. Can you help me understand what part I'm missing here?

[Djeayzonne]

Yeah, I think you just fill out a form saying that the business is terminated, which also closes the solo 401k so you can't make any more contributions to it.

If you want, then you just create a new business entity and open a new solo 401k if you want to keep contributing. In that case, you might as well just keep the original one going unless you specifically want to close it for ira conversion.

Regarding LLC vs. sole proprietor and taxes, you are a LLC taxed as either a sole proprietor or a corporation.

If you elect to be taxed a corporation, you have to run payroll and decide on a salary for yourself. You will then be a W2 employee of your company.
You can then only contribute 25% of your W2 salary.

I was seriously considering going S-corp to reduce self-employment tax, but I decided it wasn't worth it primarily because of the reduced employer contribution to the solo 401k.
That and the payroll expenses, increased cost of CPA, unemployment taxes, etc. It seems that you might be more likely to get audited as well.
But, if you can pay yourself a salary that maxes or nearly maxes out the total limit of 53K, and it still makes business sense to be taxed as a corporation, then cool.

[dandarc]

If your LLC (taxed as S-Corp) has 100K in revenue and pay yourself 100K in salary, your LLC is losing money.  You have expenses - employer share of FICA, and employer-side of 401K at minimum.

You might get away with that for a year or two, but eventually the IRS is going to ask why you're continuing to run this LLC that loses money year after year and look at your books and then you'll really have a problem.

The 25% of salary for Corp and 20% of net for proprietor simply equalizes the 2 situations - you can't actually put more in via LLC than proprietor.  The underlying assumption is that your corporation will at least break-even each year.  So if you want to have an LLC, just know "so I can put more in my SoloK" isn't really a valid reason.  Most people that go with an LLC do so to reduce FICA taxes, but then you're taking lower salary, so you're actually able to contribute less to the SoloK - exactly the opposite of what you want to do.

[DavidAnnArbor]

I called Fidelity and they told me I couldn't withdraw or convert any of the Solo 401k funds until a "life event" at the age of 59 1/2. They said this was a Fidelity and Vanguard policy, not an IRS policy. My goal is to retire long before then and convert those funds to Roth IRA using five year ladder approach (still learning the details of this). Has anyone else encountered this? Could I just start with Fidelity (since they offer ETFs, individual stocks, and no fees unlike Vanguard) and then just transfer the funds later somewhere else where I'll be allowed to convert the funds? Are there some plan administrators who charge low or no fees that would allow me to convert the solo 401k to a Roth?

I would believe retiring is a life event that should enable you to rollover your Solo 401K into a traditional IRA.
I do use Fidelity for a Solo 401K.

[Truthseeker]

Thanks so much for all of your advice. This was my first time posting a question on the forum and I'm very happy I did. I called Fidelity and spoke to a representative that seemed to be a bit more versed in the policy details. Apparently, a "life event" can include simply "retiring" and then I could transfer that money into a traditional IRA and then over to a Roth IRA when my income is lower. I did do some initial calculations below on merits of an LLC vs. sole proprietor if I considered $100k in 1099 income and filing as an S Corp claiming $60k in W2 income.

Sole Proprietor:
$100k income
$18,000 in employee 401k contribution
$18,547 in employer contribution
Total 401k Contribution: $36,547
15.3% employer tax on $100k-$36,547 = $63,453 * 15.3% = so $9,708 (have to pay all other taxes regardless so just focusing on payroll since my 1099 work is basically all W2 in reality)

LLC filed as S Corp:
$100k income - $60k as W2 (using internet salary justifications of "reasonable" salary for my type of work)
$18,000 in employee 401k contribution
$15,000 in employer contributions (25% of 60k)
Total 401k contributions: $33,000
15.3% employer tax on $60,000 - $33,000 (assuming I deduct out 401k contributions from W2 right?) = $27,000 * 15.3% = $4,131
LLC establishment fee = $225
Corporate tax filing = $1,500 (anyone have a cheaper accountant or even one that doesn't charge $200/hour to answer questions)?
Payroll = $100/month (if I have someone else do it) so $1,200

So while it looks like I save $5,577 in taxes by filing as an S Corp, I would incur $2,925 in fees to operate so only save about $2,652 in taxes, but would obviously increase my audit risk. I'd be able to stash away a bit more as a sole proprietor as well. Am I thinking about this correctly? What else am I leaving out? Is there any justification based on my scenario above to risk going the LLC route?

[DavidAnnArbor]

Also, as an S Corp. for tax purposes, you also would have to pay for Federal and State Unemployment Taxes, so not sure how much that would cost you. MrMoneyMustache actually has a column devoted to this very issue of S-Corp. versus Sole Proprietor:

http://www.mrmoneymustache.com/2016/02/10/should-you-do-your-own-taxes/

[Interest Compound]

Note, employER contributions (+gains from those contributions) have different withdrawal rules than employEE contributions (+gains from those contributions). Your employER contributions can be rolled over to a Traditional IRA after two years in the account. While the employEE contributions can't.

https://www.mysolo401k.net/making-solo-401k-distributions/

https://thefinancebuff.com/in-service-withdrawal-the-law-and-the-plan-rules.html

If you plan on doing the Roth ladder, you should consider keeping the employEE and employER contributions separate, by putting them in separate funds (not ETFs) as described in this thread:

https://www.bogleheads.org/forum/viewtopic.php?f=1&t=183502&p=2789544

Then you can easily do the withdrawal, without worrying about doing the math wrong when trying to determine the split after multiple years of dividends + contributions.

[Truthseeker]

Note, employER contributions (+gains from those contributions) have different withdrawal rules than employEE contributions (+gains from those contributions). Your employER contributions can be rolled over to a Traditional IRA after two years in the account. While the employEE contributions can't.

https://www.mysolo401k.net/making-solo-401k-distributions/

https://thefinancebuff.com/in-service-withdrawal-the-law-and-the-plan-rules.html


Thanks for your advice. I really appreciate the time you took to comment. I did call two Fidelity advisors and stopped into the local Fidelity branch as well. I was told the different withdrawal rules for employEE vs. employER contributions pertained to a SIMPLE IRA and this did not pertain to a solo 401k. At the end of the day when the "life event" (i.e., I want to transfer the solo 401k to a traditional IRA) I'll transfer all of it so I'm not sure if the distinction between employer and employee contributions matters does it?