In this article, we discuss a Solo 401k tax strategy to maximize your contributions. This tax strategy is called a non-deductible contribution, which is not new. However, in light of new IRS regulations, it is more appealing to make after-tax contributions in your Solo 401k plan.
Your Solo 401k Tax Strategy
In the case of an IRA, most people know that you can make IRA in pre-tax, after-tax, or Roth. However, it is not widely known that a Solo 401k plan can allow you to make non-deductible plan contributions based off your income on a dollar for dollar basis.
This Solo 401k Tax Strategy can prove very useful for many people.
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 you make a distribution.
Unlike pre-tax elective contributions, a Roth 401(k) plan contribution is an after-tax contribution that is currently includible in gross income. At the time of a distribution, it’s generally tax-free.
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.
Solo 401k Tax Strategy for Non-Deductible Contributions
Generally, if you’re over age 50, you can make employee deferrals in a pre-tax fund or Roth. You can do so up to $19,000 or $25,000. A profit sharing contribution can be made in pre-tax funds in amount of or equal to 25% or compensation.
In the case of self-employment or a single member LLC, the compensation is equal to 20%.
With both contributions, you cannot exceed $56,000 or $62,000 in the aggregate for 2019. An after-tax deferral, (neither Roth or pre-tax), is also an option that can go up to $56,000 or $62,000. It includes other plan contributions such as employee deferrals and profit sharing.
For example, if a 40-year-old self-employed individual earns $100,000 in 2019, he or she can make a maximum employee deferral contribution of $19,000 in pre-tax funds or Roth. He or she can make an after-tax contribution dollar-for dollar equal to $37,000.
This is the difference between $56,000 (the maximum annual 401(k) contribution for 2019) and $19,000, the maximum employee deferral contributions limit.
Convert to Roth
Individuals can then convert these contributions 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 rather than a profit sharing contribution.
Profit sharing contributions are based off a percentage of your compensation (20% or 25%). If you make a profit sharing contribution instead of an after-tax contribution, you can only make a $20,000 contribution. This will give you an annual contribution of just $39,000 versus $56,000 if employee deferrals were combined with after-tax contributions.
Is the Nondeductible 401(k) Contribution Option New?
Non-deductible 401(k) plan contributions are not new. However, new IRS regulations make after-tax contributions more appealing. The rules also allow you 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 401k Plans Allow for Non-Deductible contributions?
Not all Solo 401k plans allow non-deductible contributions. You must check the 401(k) plan documents to confirm that the plan allows for non-deductible contributions.
IRA Financials’ Solo 401k Plan allows for non-deductible contributions, in addition to pre-tax and Roth contributions.
Get in Touch
Do you still have questions regarding the Solo 401k tax strategy, such as contributions? Contact IRA Financial Group directly at 800-472-0646 to receive answers to your questions. You can also get in touch with our 401(k) specialists by filling out the form.