Last Updated on June 15, 2021
A few year ago, I wrote a book titled, “In God We Trust – In Roth We Prosper” which pretty much sums up why I am such a huge lover of Roth accounts. The major advantage of a Roth-type of account is that so long as you are over the age of 59 1/2 and the Roth IRA or Roth 401(k) account is opened at least five years, all Roth withdrawals, including gains, are tax-free. That is why many tax professionals believe the Roth IRA to be the best legal tax shelter.
- One can use the “backdoor” to supersize his or her Roth savings
- Contributing after-tax funds to a retirement plan and then converting them is the key.
- Enjoy tax-free distributions once you reach age 59 1/2.
“Backdoor Roth IRA” contributions
For 2021, the maximum Roth IRA contribution is $6,000 or $7,000 if one is at least age 50, subject to certain income limitations. For example, if one is single and earns over $140,000 or married and files jointly and earns over $208,000, one is not permitted to make Roth IRA contributions. However, since 2010, the income limitations on Roth conversions have been eliminated creating a loophole known as the “Backdoor Roth IRA.”
The “Backdoor Roth IRA” solution blueprint allows anyone with income to make an after-tax IRA contribution and then immediately convert the after-tax funds to Roth tax-free. In other words, even if one earns more than the Roth income threshold limitations, one can still indirectly make Roth contributions by simply making an after-tax IRA contribution and then immediately converting the funds to Roth. The “Backdoor Roth IRA” solution will allow anyone with income, irrespective of the sum of the annual income, to make Roth IRA contributions even if you have access to a 401(k) plan at work.
“Backdoor Roth Solo 401(k)”
For 2021, anyone that has access to a 401(k) plan at work can make employee deferral contributions of up to $19,500 or $26,000 if at least age 50. Furthermore, many 401(k) plan allow employees to make the employee deferral contributions in pretax or Roth. You are probably do some quick math in your head and figuring out that making a $6,000 or $7,000 Roth IRA contribution plus a $19,500 or $26,000 401(k) contribution does not equal $700000. Well, you are right. However, if you are self-employed or have a small business with no full-time employees other than another business owner(s) or a spouse of a business owner(s), you can establish a Solo 401(k) plan and make Roth contributions of up to $58,000 or $64,500 if age 50+. Let me explain.
The “Backdoor Roth Solo 401(k)” strategy will allow a self-employed individual or small business owner with no employees to contribute up to $58,000 of $64,500 in 2021 in a Roth on a dollar-for-dollar basis. The “Backdoor Roth Solo 401(k)” strategy generally is only available for Solo 401(k) plans since it is not subject to the top heavy and other ERISA annual plan testing rules which limits its availability for almost all traditional 401(k) plan or defined contribution plans. The “Backdoor Roth Solo 401(k)” strategy works because after-tax contributions are not treated as employee deferrals or employer profit sharing contributions. After-tax contributions are basically in a category of their own, which creates some very exciting tax planning opportunities.
Not all Solo 401(k) plans are the same. They don’t all offer after-tax contribution options, including most plans you will receive from traditional financial institutions. Hence, if you are interested in taking advantage of the “Backdoor Roth Solo 401(k)” strategy make sure to inquire that the plan allows for after-tax contributions.
The “Backdoor Roth Solo 401(k)” strategy is simple to do. Simply make a contribution to the plan up to the annual limit. I suggest you open a separate bank account under the plan for the after-tax contributions to keep everything clean. You then have two options. First, you can convert the after-tax funds to Roth in the plan tax-free. Second, make an in-plan service distribution to an after-tax IRA and then convert the after-tax funds to a Roth IRA. After-tax contributions are one of the few exceptions to the prohibition on in-plan service distributions. In both options, one will be able to get up to $58,000 or $64,500 to a Roth 401(k) or Roth IRA via the “Backdoor Roth Solo 401(k)” strategy.
“Backdoor Roth Solo 401(k)” – How Does it Work?
After-tax 401(k) contributions are not treated as employee deferral or employer profit sharing contributions and can be made on a dollar-for-dollar basis. For example, a self-employed individual over the age of 50 who makes $70,000 of income would be able to contribute $26,000 as an employee deferral, in pretax or Roth, and 20% of his or her compensation or $14,000 as a pretax employer profit sharing contribution, providing him or her with an aggregate plan contribution of $40,000 for the year.
Whereas, if the individual employed the “Backdoor Roth Solo 401(k)” strategy, he or she would be able to contribute $64,500 to the plan and immediately convert the funds to Roth and even roll them over to a Roth IRA without tax. Thus, by doing a “Backdoor Roth IRA” of $7,000 to a Roth IRA plus taking advantage of the “Backdoor Roth Solo 401(k)” of $64,500, one can contribute over $70000 to a Self-Directed Roth IRA in 2021.
Therefore, if you are eligible to set-up a Solo 401(k) and are a Roth lover who wants to have all your retirement funds in a tax-free account, combining the “Backdoor Roth IRA” with the “Backdoor Roth Solo 401(k)” can prove to be the ultimate Roth strategy and potentially allow you make Roth contributions to a Self-Directed Roth IRA of over $70000 if you are at least age 50.
Even if you are younger than 50, you can still supersize your Roth savings by utilizing the strategy. In fact, the more time you have until you retire, the more your money can grow. The great part is that it will all be without tax when you need it most.