Thinking about closing your self-directed Solo 401k? It’s a decision that can arise in a number of situations, especially as your business or personal circumstances evolve.
A self-directed Solo 401k offers self-employed individuals greater control and higher potential contribution limits, but it also comes with specific IRS eligibility rules.
If you retire, close your business, or hire full-time employees, you may no longer meet those requirements. In such cases, properly closing the plan helps maintain compliance and avoid potential penalties.
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So how do you know when it’s time? Let’s explore the common situations where closing your self-directed Solo 401k may be necessary.
📌 Also Read: The Self-Directed Solo 401k Explained
Common Reasons to Close a Self-Directed Solo 401k
These are the most common situations where closing your self-directed Solo 401k might be the right move and help you stay compliant with IRS rules:
1. Retirement
If you’re fully retiring and no longer earning self-employment income, you typically no longer qualify to maintain a self-directed Solo 401k.
The IRS requires that Solo 401k participants be actively self-employed to continue making contributions. Once you exit your business entirely, the plan becomes inactive — meaning it’s time to take action to close it.
2. Business Closure
If your business shuts down and you’re no longer self-employed, you’re generally not allowed to keep your self-directed Solo 401k open. That’s because the plan is only available to individuals who actively run a business with no full-time employees (other than a spouse). Once the business is no longer operating, the IRS considers the plan ineligible to continue.
To stay compliant, you’ll need to:
- Formally terminate the plan
- Distribute or roll over the remaining assets
- File a final Form 5500-EZ with the IRS if the plan had $250,000 or more in assets
📝 Important Note: Skipping these steps could lead to missed filings or penalties. Even if your business closure is temporary or unplanned, the IRS doesn’t allow you to keep the Solo 401k open without valid self-employment activity.
3. Hiring Full-Time Employees
Self-directed Solo 401k plans are meant for owner-only businesses with no full-time employees. Once you hire a W-2 employee who meets the eligibility criteria under the SECURE Act 2.0 (age 21+ and working more than 500 hours for three consecutive years), the employee becomes eligible to participate in your retirement plan.
Since a Solo 401k doesn’t support multiple participants, you may need to:
- Terminate the plan
- Distribute or roll over the assets
- Establish a traditional 401k plan that includes employee participation
📝 Timing matters — waiting too long to take action after hiring could result in compliance issues or plan disqualification.
📌 Also Read: Can A W-2 Employee Contribute to a SEP IRA?
4. Transitioning to a Different Retirement Plan
If your business is expanding or your retirement strategy has changed, you may opt to move to another plan, such as a SEP IRA, SIMPLE IRA, or traditional 401k. In most cases, you’ll need to terminate your existing Solo 401k plan before contributing to the new one.
Switching to a new plan without formally closing your Solo 401k could lead to:
- Excess contributions
- Conflicting plan rules
- IRS reporting issues
To avoid these risks, it’s generally best to terminate the Solo 401k before funding your new retirement account. This helps you stay organized and avoid problems with contribution limits or plan eligibility.
📌 Also Read: SEP IRA vs SIMPLE IRA: Similarities and Differences
IRS Requirements to Close Your Solo 401k
The IRS has specific requirements when it comes to closing your Solo 401k plan. Make sure you understand these requirements to stay compliant and avoid potential penalties.
Mandatory Filings
If you’re closing your self-directed Solo 401k, you must file Form 5500-EZ with the IRS, regardless of your plan’s asset value. This form reports the plan’s termination and ensures compliance with IRS regulations.
Typically, Form 5500-EZ is due by July 31 of the year following the plan’s termination. For example, if you terminate your plan in 2025, the form should be filed by July 31, 2026. Failing to file can result in penalties of up to $250 per day, with a maximum of $150,000 per plan year.
📝 Important Note: Even if your plan’s assets are below $250,000, filing Form 5500-EZ is still required upon termination.
Distribution of Assets
Upon terminating your Solo 401k, the IRS requires that all plan assets be distributed as soon as administratively feasible, generally within 12 months of the plan termination date.
Options include:
✅ Rollover to a traditional IRA or another eligible plan to maintain tax-deferred status.
✅ Direct distribution to the account holder (subject to income tax and possibly early withdrawal penalties)
📝 Important Notes:
- If you’re under age 59½, a 10 percent early withdrawal penalty may apply.
- Timely distribution is crucial. If assets remain in the plan beyond the administratively feasible period, the IRS may consider the plan ongoing, subjecting it to continued compliance requirements.
Vesting Rules
When a Solo 401k plan is terminated, all plan participants become 100% vested in their account balances, regardless of the plan’s original vesting schedule.
This means any employer contributions that were subject to a vesting schedule become fully owned by the participant upon plan termination. Employee contributions are always fully vested.
Ensuring full vesting upon termination is essential to comply with IRS regulations and to protect participants’ rights to their retirement savings.
Not Ready to Close? Here Are Other Options
If you’re not quite ready to close your self-directed Solo 401k, there are alternative strategies to consider:
Freezing the Plan
If you’re uncertain about the future of your business or going through a temporary pause in self-employment income, you may consider freezing your Solo 401k. This stops new contributions but keeps the plan active.
However, it’s important to note that a frozen plan is still considered active by the IRS and must comply with all applicable requirements, including:
- Filing annual returns: Even if no contributions are made, you must continue to file Form 5500-EZ annually if your plan’s assets exceed $250,000.
- Maintaining plan documentation: Ensure your plan document is kept up to date with current laws and regulations.
- Compliance with qualification rules: The plan must continue to meet the requirements of Internal Revenue Code Section 401(a) to retain its tax-qualified status.
Upgrading to a Traditional 401k
If your business has grown and you’re planning to hire eligible employees, transitioning from a Solo 401k to a traditional 401k plan may be required. Solo 401k plans are designed for businesses with no employees (other than the owner and their spouse). Once you hire eligible employees, you’re generally required to offer them participation in your retirement plan.
Upgrading to a traditional 401k involves several steps:
- Plan termination: You’ll need to formally terminate your Solo 401k plan, distribute its assets, and file a final Form 5500-EZ.
- Establishing a new plan: Set up a traditional 401k plan that accommodates multiple participants and complies with nondiscrimination testing and other regulatory requirements.
- Employee communication: Inform your employees about the new plan, including eligibility, contribution options, and benefits.
📌 Not ready to close entirely? You can move your Solo 401k assets into a Carry IRA instead. See your rollover options here.
Wrapping It Up
Knowing when and how to close a self-directed Solo 401k is essential for staying compliant and protecting your retirement savings. Whether due to retirement, business changes, or hiring employees, certain events make plan termination both necessary and required.
The IRS expects you to follow specific rules when closing the plan, including distributing assets, ensuring full vesting, and filing Form 5500-EZ. Delaying or skipping steps could result in tax penalties and compliance risks.
If you’re unsure how to proceed, it’s generally a good idea to consult a qualified tax or financial professional. Everyone’s situation is unique, and making the right move can help secure your financial future.
Disclaimer:
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