In the case of an IRA, most people know that IRA contributions can be made in pre-tax, after-tax, or Roth. However, it is not widely known that a Solo 401(k) plan can allow you to make non-deductible plan contributions based off your income on a dollar for dollar basis.
Types of Plan Contributions
A contribution to a pre-tax 401(k) plan is a tax-deductible contribution; however, it is subject to tax when distributed. Unlike pre-tax elective contributions, a Roth 401(k) plan contribution is an after-tax contribution that is currently includible in gross income but generally tax-free when distributed. Whereas, when after-tax plan contributions are made from an employee’s compensation (other than Roth contributions), then an employee must include it as income on his or her tax return.
Non-Deductible 401(k) Plan Contribution Tax Strategy
Generally, when an individual is over the age of 50, he or she is able to make employee deferrals in a pre-tax fund or Roth of up to $18,500 or $24,500. A profit sharing contribution can be made in pre-tax funds in the amount equal to 25% of compensation (20% in case of self-employment or a single member LLC), and both contributions cannot exceed $55,000 or $61,000 in the aggregate for 2018. An after-tax deferral, (neither Roth or pre-tax), is also an option that can go up to $55,000 or $61,000 and include other plan contributions such as employee deferrals and profit sharing. For example, if a 40-year-old self-employed individual earns $100,000 in 2018, he or she would be able to make a maximum employee deferral contribution of $18,500 in pre-tax funds or Roth and make an after-tax contribution dollar-for dollar equal to $36,500. This is the difference between $55,000 (the maximum annual 401(k) contribution for 2018) and $18,500, the maximum employee deferral contributions limit. Those contributions can then be converted to a Roth. The advantage of making after-tax contributions versus a profit sharing contribution is that you can make a dollar for dollar contribution as opposed to a profit sharing contribution, which is based off a percentage of your compensation (20% or 25%). If a profit sharing contribution were made instead of an after-tax contribution, the individual would only be able to make a $20,000 contribution, giving him or her an annual contribution of just $38,500 versus $55,000 if employee deferrals were combined with after-tax contributions.
Is the Nondeductible 401(k) Contribution Option New?
No, Non-deductible 401(k) plan contributions are not new, but new IRS regulations (Notice 2014-54) make after-tax contributions more appealing and allows the retiree to effectively segregate the after-tax assets from the pre-tax funds. The pre-tax funds can be rolled into a Traditional IRA, whereas the after-tax dollars can be converted into a Roth IRA.
Do All Solo 401(k) Plans Allow for Non-Deductible contributions?
No. You must check the 401(k) plan documents to confirm that the plan allows for non-deductible contributions. IRA Financial Group’s Solo 401(k) Plan allows for non-deductible contributions, in addition to pre-tax and Roth contributions.