Solo 401(k) Tax Strategy to Maximize Contributions
Many investors know about the possibility of making IRA contributions in one of two forms: pretax or Roth. But only a select few have really gone deep in the rules and regulations enough to discover that a Solo 401(k) plan allows non-deductible plan contributions based on an employee’s income, on a dollar-for-dollar basis. This tax strategy can be very advantageous for investors. It’s a trick allowed under the rules more commonly known as the Mega Backdoor Roth 401(k) Conversion. This article will explore different 401(k) plan contribution options and focus on the Mega Backdoor Roth 401(k) strategy.
Types of 401(k) Plan Contributions
Pretax Solo 401(k) Plan Contributions
A pretax 401(k) contribution is tax-deductible up front but may be subject to federal income tax when a distribution is made. In 2023, the Solo 401(k) contribution rules allow a participant under the age of 50 to make a maximum employee deferral contribution of $22,500. That amount can be made in pretax or after-tax (Roth). On the profit-sharing side, the business can make a 25% (20% in the case of a sole proprietorship or single member LLC) profit sharing contribution, which, including the employer-based deferment, offers a combined maximum of $66,000 (compared to $61,000 in 2022) in deferments. Employer contributions must be made in the pretax form. In 2023, plan participants who are at least age 50 can make a maximum employee deferral contribution of $30,000. That amount can be made in pretax or after-tax (Roth), up to a combined maximum, including the employee deferral, of $73,500 (compared to $67,500 in 2022).
Roth Solo 401(k) Plan Contributions
A Roth Solo 401(k) contribution is a contribution of after-tax funds. In other words, contributions are made with income that has already been subject to income tax. One does not receive an income tax deduction for making a Roth 401(k) plan contribution, but if the participant is over the age of 59 ½ and the Roth 401(k) is five years old, all Roth Solo 401(k) plan distributions would be tax free.
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Solo 401(k) Tax Strategy for Non-Deductible Contributions – Mega Backdoor Roth Solo 401(k)
The “Mega Backdoor” Roth Solo 401(k) strategy is highly beneficial tax plan for anyone with a Roth IRA. This technique allows a self-employed individual or small business owner with no employees to contribute up to $61,000 or $67,500 (if at least age of 50), on a dollar-for-dollar basis. In 2022, pursuant to IRC Section 415, the aggregate limit for employee and employer contributions was $61,000, or $67,500 for participants over 50. These numbers have been increased to $66,000 and $73,500, respectively, for 2023. The “mega backdoor” Roth strategy generally is only available for Solo 401(k) plans because these plans are not subject to various testing rules (ERISA, Top Heavy, etc.). These limit its availability to all other traditional 401(k) plans or defined contribution plans.
After-tax or non-deductible 401(k) contributions are not considered employee deferrals or employer profit sharing contributions under the IRC and may be made on a dollar-for-dollar basis. For example, a self-employed individual under the age of 50 who makes $80,000 of W-2 wages would be able to contribute $20,500 as an employee deferral, in pretax or Roth format, and 20% of his or her compensation, or $14,000, as a pretax employer profit sharing contribution (in 2022), providing him or her with an aggregate plan contribution of $34,500 for the year. In total, if the Mega Backdoor Roth strategy is appropriately used, the participant could contribute as much as $61,000 to the plan, convert the funds to Roth form, and even roll them over to a Roth IRA – TAX FREE!
Thank you IRA Financial for helping me pursue a Backdoor Roth 401(k)! Before talking to your experts, I never knew this was an option. Your customer service representatives helped me throughout the process. I would highly recommend IRA Financial to anyone looking to pursue a Self-Directed retirement account
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How Does the Mega Backdoor Roth 401(k) Work?
IRS Notice 2014-54 opened the door to the Mega Backdoor Roth 401(k) technique, as it expressly allowed pretax and Roth funds to be distributed from a 401(k) plan separately. Because after-tax contributions are not considered employee contributions or employer profit sharing contributions under ERISA, such contributions would technically not be subject to plan’s triggering event rules. As a result, after-tax contributions can now be rolled into a Roth 401(k) tax free and without a plan triggering event. In other words, the IRS accelerated the popularity of the Mega Backdoor Roth strategy because it allowed for after-tax Solo 401(k) plan contributions to be rolled over to an after-tax IRA at any time, all while allowing a subsequent conversion of the contribution to a Roth IRA as an in-service plan withdrawal.
Is the Non-Deductible Solo 401(k) Contribution New?
The non-deductible 401(k) plan contribution is not a new invention. However, the IRS’s own notice makes non-deductible contributions more appealing to any investor. As detailed above, this technique offers the ability to make non-deductible contributions to a Solo 401(k) plan, dollar-for-dollar, up to the maximum contribution amount of $61,000 or $67,500 in 2022, and $66,000 or $73,500 in 2023. This is a massive tax planning opportunity for Roth lovers.
Do all Solo 401(k) Plans Allow Non-Deductible Contributions?
Not all Solo 401(k) plans allow non-deductible contributions. In other words, not all Solo 401(k) plans allow you to make Mega Backdoor Roth Solo 401(k) contributions. Before you do anything, you must review your plan documents to confirm that the plan allows for non-deductible contributions.
The IRA Financial Self-Directed Solo 401(k) plan allows a business owner to take advantage of the Mega Backdoor Roth Solo 401(k) strategy, with both pretax and Roth contributions. If you have any questions, contact IRA Financial directly at 800-472-0646 and one of our 401(k) specialists can assist you.