Last Updated on March 10, 2020
IRA Financial’s Adam Bergman discusses the mega Roth 401(k) and explains how it works, the benefits of it and why you should know about it.
In his latest “Adam Talks” podcast, Mr. Bergman talks about how a mega Roth 401(k) can help you maximize after-tax contributions, dollar-for-dollar. It’s a little known strategy that can pay off once you reach retirement age. Please note, that this strategy is generally for the self-employed and owner-only businesses.
What is a Solo 401(k)?
To make mega Roth 401(k) contributions, you need to utilize a Solo 401(k). This is mainly because you are in complete control of the plan. Taking advantage of the high contribution limits can only be attained this way. To be eligible for a Solo 401(k), there must be two things in place. First, you need any type of self-employment income. This can be from side (or gig) jobs, any type of freelance work, or from a business you own. Secondly, is the absence of any full-time employees. Therefore, if you own a business, you cannot have any full-timers working for you, expect for a spouse or other owner. If those two caveats are satisfied, you may start up a Solo 401(k).
A Solo 401(k) offers a great number of benefits and is, arguably, the best retirement plan for the self-employed. In addition to the annual 401(k) limit you may contribute as an employee, there’s the added benefit of contributing to the plan as the employer. For 2020, you may contribute up to $19,500 as an employee to a 401(k). If you are at least age 50, you may contribute another $6,500, for a total of $24,000. When using a Solo 401(k), you may contribute as the employer up to a total maximum of $57,000 ($63,500 if at least age 50) for 2020.
Further, if you work with the right provider, such as IRA Financial, you have complete control of your investment choices. With our Checkbook Control structure, you never need custodial consent to make an investment. The prohibited investments set forth by the IRS are very few. Therefore, the investment possibilities are almost limitless.
What is a Roth 401(k)?
A Roth 401(k) is a plan that allows for after-tax contributions. This is unlike a traditional plan that is funded with pre-tax money. The benefit of a Roth is that all qualified distributions are tax-free during retirement! A lot of people don’t know about the Roth 401(k) since it’s not widely offered by many companies. Usually, your only choice at a company you work for is the traditional plan.
However, if you are self-employed, you don’t have other people making your retirement planning decisions for you. You just need a provider that offers a Roth option within their Solo 401(k) plan offerings. IRA Financial believes strongly in the power of tax-free investing. Yes, traditional plans offer a nice, upfront tax break. But wouldn’t you want tax-free income once you stop working? Read on to see how you can supercharge your savings.
The Mega Roth 401(k) Plan
As we mentioned earlier, you may contribute to a Solo 401(k) as both the employee and employer. The employee deferral is always the same, no matter the type of plan. However, employer contributions are generally limited to 20 or 25% of your income, depending on the type of self-employed income you have. For example, if you earn $40,000 per year, you can contribute $19,500 as an employee. In addition, you may contribute 20% of your salary for an extra $8,000 as the employer. This gives you a total of $27,500 for the year. However, there is a way you can contribute the entire amount to your 401(k) if you so choose!
Obviously, the first thing that needs to be in place, is that you know that it can be done. That’s what we’re here for! Secondly, your provider must allow for mega Roth 401(k) contributions. Finally, you must have enough earned income to maximize your contributions.
If you are a high earner, making hundreds of thousands of dollars each year, this strategy is not for you. You can maximize your contributions based on the percentage of your income. However, if you earn $60, $80, even $100 thousand each year, you may want to consider the Mega Roth 401(k). This will allow you to contribute up to the maximum allowable limit.
How Does it Work?
As Mr. Bergman mentions in the podcast, your CPA may lead you to the tax deductions a traditional plan offers. However, is the immediate tax break imperative to you? Would you rather pay taxes now (at a known rate) or defer them until you start withdrawing at retirement? Decades of tax-free growth probably is the more appealing option.
Essentially, to make dollar-for-dollar contributions based on your income, you need to make your 401(k) contributions as after-tax contributions. To be clear, these are not direct Roth contributions. Thanks to IRS Notice 2014-54, you are allowed to convert after-tax contributions to a Roth 401(k), assuming your plan allows for it. You are not handcuffed based on the income you earn now. It doesn’t matter if you make $1 million or exactly, $57,000, you can contribute the entire amount to your Solo 401(k).
Again, to be clear, this strategy only makes sense if you convert the contributions to a Roth. After-tax contributions do not receive a tax deduction. Further, non-Roth distributions are not tax-free. Therefore, it makes no sense to not convert to a Roth!
Time to Decide
It’s up to you, along with your CPA or financial planner, to really determine if the mega Roth 401(k) strategy works for you. Are you better off with the upfront tax deduction, or can you afford to pay taxes now and reap the benefits during retirement? Only you can really answer that question. It’s best to be informed of all of your options before deciding!
Listen to the podcast, as Mr. Bergman goes into more detail about how the strategy works. Also, be sure to check out our SoundCloud page for all the podcasts from our “Adam Talks” series. As always, thanks for listening!