In this article, we’ll explain some of the complexities behind a Solo 401(k) tax strategy and how it is designed to maximize your contributions. This tax strategy is also called a non-deductible contribution, and this is not a new concept for experienced financial experts. However, in light of new IRS regulations, it is has become even more appealing to make after-tax contributions into your Solo 401k plan.
What is a Solo 401(k)?
What has become known as a “Solo” 401(k) plan is nothing new. In fact, they have been a solid tax reduction strategy for decades. Sometimes, they go by different names, such as an individual 401(k) or self-employed 401(k) plan, but no matter how you spell it, this type of 401(k) is required for any business without non-owner, full-time employees. For IRS purposes, a non-owner full-time employee is defined as any non-owner employee (including spouses) that works more than 1,000 hours annually (or maintain three consecutive years with no less than 500 hours of service).
Your Solo 401(k) Tax Strategy
In the typical IRA plan, most people correctly assume that you can fund the IRA in one of three forms: pretax, after-tax, or Roth. However, few people are aware that a Solo 401(k) plan might allow you to make non-tax deductible plan contributions based off your income on a dollar-for-dollar basis. In 2023, the maximum 401(k) tax deferred employee contribution is $22,500, or $30,000 if the employee is at least age 50 (compared to $20,500 and $27,000, respectively, in 2022).
Utilizing a Solo 401(k) tax strategy can prove very advantageous for most self-employed or small business owners seeking to maximize their retirement savings.
Types of Plan Contributions
There are three types of Solo 401(k) employee deferral contributions to consider in planning your personal tax strategy: (i) pretax, (ii) non-deductible, and (iii) Roth. Because each has specific tax implications, we will discuss them in turn.
- Solo 401(k) Employee Pretax Contribution: These account for the most common type of employee deferral contributions, primarily because most employees make pretax employee deferral contributions through their employer. Importantly, these pretax employee deferrals are fully tax deductible, making the pretax contribution an offset from the participant’s taxable income. To illustrate, if an employee earns $60,000 in W-2 wages and makes a $12,000 pretax employee contribution, the $12,000 pretax contribution would reduce the individual’s taxable income from $60,000 to $48,000. Obviously, this would ultimately reduce tax due. One additional consideration exists for employees over the age of 59 ½. There, any pretax distributions from a pretax 401(k) is subject to ordinary income tax.
- Solo 401(k) Non-Deductible Contribution: There is only one reason to make a non-deductible contribution to a Solo 401(k) plan – the “Mega Backdoor Roth Conversion.” In 2023, this strategy allows one to contribute up to $66,000 or $72,500 (compared to $61,000 or $67,500 for 2022). If you’re over 50, you can contribute dollar-for-dollar, into an after-tax 401(k) and then immediately convert the funds to a traditional Roth 401(k) or a Roth IRA. This “Mega Backdoor Roth” strategy is a powerful solution for any anyone that wants to maximize their Roth contributions. Beyond that, there is no reason to make a non-deductible Solo 401(k) contribution because there would be no tax deduction and the earnings would be subject to tax.
- Solo 401(k) Employee Roth Contributions: In a Solo 401(k) plan, only employee deferrals can be made in the form of a Roth. Employer profit sharing contributions (20% of net Schedule C or 25% of W-2) must be made in the pretax form. Further, not all Solo 401(k) plans offer a Roth employee deferral contribution option. Unlike a Roth IRA, which comes with an income threshold, there are no income thresholds for making Roth Solo 401(k) employee contributions. Yes, the Backdoor Roth IRA Conversion is a workaround, but it comes with its own challenges. Unlike a pretax employee contribution, which is tax deductible, a Roth employee contribution is not taxable and is made with after-tax funds. For example, if one earns $60,000 in W-2 income and make a $12,000 Roth employee deferral contribution, the individual owe income tax on the full $60,000 of their W-2 wages. Importantly, for anyone over the age of 59 ½ with a Roth that has been open for at least 5 years, all Roth 401(k) distributions would be tax-free, marking the primary advantage of a Roth 401(k) account versus a pretax 401(k).
Solo 401(k) Employer Profit Sharing Contributions
Another wrinkle in this taxation plan is that through an employer, additional contributions can be made, up to 25% of the participant’s self-employment compensation (or 20% in the case of a sole proprietor or single member LLC). Employer contributions made by the business are 100% elective, but they must be made prior to the business filing its tax return. Employer “profit sharing” contributions must be made in a pretax form but can be converted to Roth so long as your plan allows it. Employer contributions are typically calculated as a percentage of the plan participant’s W-2 amount, guaranteed payment, or net Schedule C amount, depending on the specifics of the employer’s business.
The maximum annual amount of any employee deferrals and employer contributions cannot exceed the IRC 415 limit for 2023, which is $66,000 (or $72,500 for anyone over 50). For example, if a Solo 401(k) plan participant under 50 earned $50,000 in W-2 wages, their maximum contribution would be $22,500 as an employee deferral in pretax or Roth and an employer contribution equal to 25% of her W-2 amount of $10,000, for an aggregate contribution of $32,500 for 2023. Since that amount is less than the IRC 415 amount for 2023, the contributions will be remained deductible under most situations.
Related: Solo 401(k) Investments
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.