Maximize Solo 401(k) Contributions
Solo 401(k) Tax Strategy
Many investors are aware that they can make contributions in pre-tax, after-tax or Roth. Fewer people know that a Solo 401(k) plan allows them to make non-deductible plan contributions based off their income on a dollar for dollar basis. This tax strategy can be very advantageous for investors.
Solo 401(k) Plan Contributions
A pre-tax 401(k) contribution is tax-deductible, but subject to tax when you take a distribution.
A Roth Solo 401(k) contribution is after-tax that is included in gross income. When you take a distribution, it is generally tax-free.
When you make an after-tax plan contribution with your employee compensation, then you must include it as income on your tax return (excluding Roth contributions).
Solo 401(k) Tax Strategy for Non-deductible Contributions
A little known strategy is to make non-deductible contributions to your Solo 401(k). This allows you to convert your entire contribution to a Roth Solo 401(k). Roth contributions in a Solo 401(k) can only be made as the employee, known as elective deferrals. You are limited to the employee deferral limit of $19,500 for 2020 ($26,000 if you are age 50 or older). You may contribute an additional $37,500 as the employer, known as profit sharing contributions. However, profit-sharing contributions cannot be in the form of a Roth.
Instead, you may make non-deductible, after-tax contributions and then convert those to a Roth Solo 401(k). By utilizing this strategy, you can contribute and convert the entire limit of $57,000 ($63,500 if you are 50 or older) to take advantage of the benefits of the Roth Solo 401(k).
Voluntary after-tax contributions may be distributed at any time and therefore can be converted to a Roth. Direct Roth contributions need a triggering event, such as losing your job or reaching the age of 59 ½ to be distributed.
It’s important to note that you will only have one Solo 401(k) plan. If you decide to convert funds to a Roth Solo 401(k), they will be in a sub-account of your Solo 401(k). Pre-tax and Roth funds should be kept separate for tax purposes.
It’s personally up to you if you want to split your contribution. You may choose to contribute to a Roth as an employee and contribute after-tax funds as the employer. Alternatively, you may contribute after-tax funds as both the employee and employer.
Either way, the only reason to contribute after-tax money to a Solo 401(k) is if you convert it to a Roth. Without the conversion, your earnings will be subject to tax when distributed. In that case, you are better off making pre-tax contributions to receive the tax deduction. Taxes will be deferred until you withdraw funds during retirement.
Convert to Roth
There are many benefits of converting your Solo 401(k) to a Roth Solo 401(k).
- Qualified distributions of Roth earnings are completely tax-free, whereas pre-tax contributions are taxed when distributed.
- Diversification when you contribute to a Roth and pre-tax retirement plan.
- Roth contributions are upfront, thus you pay known tax rates today as opposed to paying unknown tax rates with a pre-tax plan.
- A great option for younger generations, as you are likely in a lower tax bracket now than you will be in the future.
It's a good idea to convert your Roth 401(k) funds into a Roth IRA when you approach age 72. With a Roth 401(k), you must take a required minimum distribution (RMD) at age 72. However, there is no RMD for the Roth IRA. As a result, you can let your funds grow unhindered and create generational wealth.
Is the Non-deductible Solo 401(k) Contribution New?
A non-deductible 401(k) plan contribution is not new. However, there are new IRS regulations that make after-tax contributions more appealing. The rules 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 401(k) Plans Allow Non-deductible Contributions?
Not all Solo 401(k) plans allow non-deductible contributions. You must check the plan documents to confirm that the plan allows for non-deductible contributions.
At IRA Financial Group, our Solo 401(k) plan allows for nondeductible contributions along with pre-tax and Roth contributions. If you have any questions, contact IRA Financial Group directly at 800-472-0646 and a 401(k) specialist can assist you.
We wrote the book on the Solo 401(k)
A simple, yet informative handbook, Going Solo: America’s Best-Kept Retirement Secret for the Self-Employed was written to help small business owners and self-employed individuals discover the many advantages of establishing a Solo 401(k) Plan.
In an effort to eliminate the complexity of how one can establish an individual 401(k) plan, Adam Bergman wrote Solo 401(k) in a Nutshell. The book “…simplifies the process (of establishing a Solo 401(k) while…providing everything one needs to maximize their retirement assets” and gain financial freedom.