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
If you are over 50, you can make employee deferrals in pre-tax or Roth 401(k) of up to $19,000 or $25,000 for 2019. You can make a profit-sharing contribution in pre-tax funds in the amount of or equal to 25% of compensation (20% in case of self-employment or a single member LLC), and both contributions 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 $53,000 or $59,000 on a dollar for dollar basis and include other plan contributions such as employee deferrals and profit sharing.
For example, if you earn $100,000 in 2019, you can make a maximum employee deferral contribution of $19,000 in pre-tax funds or Roth. You 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. You can then convert your employee deferral or employer profit sharing contributions to a Roth.
The advantage of after-tax contributions versus a profit sharing contribution is that you can make a dollar for dollar contribution. Profit-sharing contributions are based off a percentage of your compensation (20% or 25%). If you make a profit sharing contribution over an after-tax contribution, you will be limited to a $20,000 contribution (20% of the $100,000 salary).
Using the after-tax contribution strategy allows you to defer an additional $17,000 versus only making employee deferrals and employer profit sharing contributions. The advantage of after-tax contributions is that the salary deferral limits that apply to other participant contributions do not necessarily apply to after-tax contribution. However, you must have disposable income available to make the after-tax contributions. If you do, this strategy can help you boost your retirement savings.
Convert to Roth
To gain the advantages of a Roth Solo 401(k), you can convert contributions to Roth. An after-tax contribution in comparison to a profit-sharing contribution is that you can make a dollar for dollar contribution rather than a profit-sharing contribution. As you may know, 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 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 401(k) 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.