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.
Did You Know?
You are allowed to contribute to your Solo 401(k), even after you reach age 72, the age you must start taking mandatory withdrawals, called required minimum distributions, or RMDs. So long as you are earning taxable income, you may contribute as much as you want, up to the annual limit. Speaking with a financial advisor makes sense to decide if you should continue to fund your retirement after 72.
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.