Defer, defer, defer. That is what people are typically looking to do with their income tax obligations. Instead of paying the income tax today, they want to shave off their taxable income by contributing to a pre-tax retirement account and defer paying the tax until the funds are withdrawn in retirement.
While this is incredibly common and a perfectly good strategy, sometimes the idea of contributing to a retirement account with Roth and/or voluntary after-tax contributions is never considered. Other times, the person does make after-tax contributions, but they use a retirement plan with a low or income-capped contribution limit, such as a Roth IRA.
The Self-Directed Solo 401(k) could be a great option for people who have income from self-employment (1099 independent contractors) or business owners with no W-2 employees working more than 1,000 hours per year who want to contribute the most after-tax dollars possible to maximize their tax-free money in retirement.
In addition to pre-tax contributions, Roth and voluntary after-tax contributions can be made and in-plan conversions to the Roth account can take place (if the plan is designed to allow for them). These provisions open the door for several strategies and opportunities to create a large pool of tax-free money in retirement.
Combined with the other beneficial features that the Self-Directed Solo 401(k) provides, such as a loan provision, investment control and flexibility through self-direction, and asset class diversification into a wide array of investment possibilities, including real estate, it could be the tax-efficiency powerhouse that people with income from self-employment have been seeking.
What are the types and limits of contributions that Self-Directed Solo 401(k) plans allow?
Pre-tax contribution Options
In order to fully maximize the two ways to contribute after-tax dollars as designated Roth and voluntary after-tax contributions, it is important to understand how the Salary Deferral and Profit-Sharing pre-tax contributions can be made.
With salary deferral, the account holder can contribute:
- 100% of net earnings/salary from self-employment up to a maximum of $19,500.
- Those who are 50 years old or older qualify for the additional catch-up contribution of $6,500, bringing the salary deferral limit to $26,000.
In addition to the salary deferral, account holders can also make a profit-sharing contribution:
- Those set up as an LLC, Partnership, or Sole Proprietor can contribute up to 20 percent of their net earnings from self-employment.
- Those set up as C Corporations and S Corporations can contribute up to 25 percent of their salary from self-employment.
The 2020 contribution limit for salary deferral and profit sharing, combined, cannot exceed $57,000 for those under 50 years old or $63,500 for those 50 years old and over. (The 2021 combined limits increased to $58,000 and $64,500, respectively). The account holder does not have to contribute the full amount; this is just the maximum that is allowed.
These plans can still be adopted up until the person’s tax filing deadline, plus extension, to make contributions that would affect their 2020 tax liability. (Certain restrictions apply, however, so a qualified Self-Directed Solo 401(k) plan provider should be consulted for details).
After-tax contribution options (if the plan is designed to include them)
Aside from contributing to a Self-Directed Solo 401(k) with pre-tax dollars, Roth and voluntary after-tax contributions can also be made. These options open the door for up to $57,000 or $63,500 (depending on age) to be contributed/converted to a Roth account every year, per future contribution limits.
The salary deferral portion ($19,500/$26,000), as explained above, can be contributed after-tax to a designated Roth account. This amount is not limited to the income cap.
100% of net earnings from self-employment (up to the annual limit) can be made as a voluntary after-tax contribution. An after-tax contribution is not considered to be “salary deferral” or “profit-sharing” so no calculations are needed to determine the amount other than ensuring that the contribution does not exceed the account holder’s net earnings from self-employment.
To prevent the investment gain and income from being taxable, the person will want to convert the after-tax contribution to the Roth account before it is invested, or earns interest, and report it with information from Form 1099-R. The strategy of contributing voluntary after-tax funds and then converting them to a Roth account is commonly referred to as a “Mega Backdoor Roth.”
5 Strategies for increasing Roth funds
1. Salary deferral only.
The person can choose to contribute their salary deferral portion directly to the designated Roth account and then put the profit-sharing contribution into the pre-tax account. This might be a good compromise to enjoy some tax deferral benefits now while still creating a pool of tax-free money available in retirement.
2. Salary deferral and profit-sharing.
For people who are not particularly concerned about tax-savings through deferral today and want to increase their tax-free money in retirement as much as possible, they could make Roth salary deferral contributions along with the pre-tax profit-sharing contributions.
They would then convert the profit-sharing contribution to the Roth account and pay the tax on it. The person can then invest all of the funds through their Roth account so that the basis, income, and gain will all be tax-free upon withdrawal.
3. Pre-tax salary deferral and profit-sharing, plus voluntary after-tax.
Contributing after-tax dollars is also a way to maximize, and reach, the contribution limit amount of $57,000 or $63,500 since it can be made in addition to the salary deferral and profit-sharing contributions.
For example, if the person can only contribute $35,000 pre-tax, instead of the full $57,000 amount allowed (assuming they are less than 50 years old) due to income restrictions, they can add $22,000 of voluntary after-tax dollars to reach the limit, and then convert the after-tax money to the Roth account.
This, again, might be a compromise to have both tax deferral today and tax-free money later.
4. Voluntary after-tax only
If the person wants to fully maximize the amount of tax-free money available in retirement, they can contribute the full annual limit (assuming they have the income level to cover it) as a voluntary after-tax contribution and then convert it to the Roth account.
5. In-plan Roth conversion (if the plan is designed to include it)
In addition to funding the account using contributions from net earnings or salary, the account holder can also roll their current retirement account(s), in part or in whole, into the plan to increase the asset class investment diversification potential and tax-free money in retirement.
Any pre-tax account can be used, such as IRAs, SEP IRAs, old 401(k)s, etc., but no pre-existing Roth, after-tax, or HSA account can be rolled into the pre-tax plan. Information from Form 1099-R will need to be used to report the rollover on Form 1040 for the tax year in which the rollover took place.
Once an existing pre-tax account is rolled into the Self-Directed Solo 401(k) plan, the person can convert it to the Roth account and pay the tax on it. Even though the tax obligation is incurred today, the conversion can be a tax-advantaged move in the long run since the account holder will essentially be taxed on the seed (or seedling) instead of the harvest.
There are tax and timing issues to consider, such as possibly being bumped up to a higher tax bracket and trying to convert funds when the market is down instead of up. When structured properly, however, the account holder can greatly increase the amount of Roth funds available for investment.
This could be particularly useful if the account holder wishes to invest in assets that will have a step up in valuation or have the ability to offset the taxes incurred from the Roth conversion with other tax losses. The account holder will want to consult with their tax advisor and financial advisor before engaging in a rollover or conversion.
The difference in retirement.
The true benefit of an in-plan conversion of pre-tax accounts will come once the Roth account holder reaches age 59½ and can take a distribution from the account without any tax consequence (but subject to the recapture rule, if applicable). The account holder can also roll it over to a Roth IRA upon retirement to avoid any Required Minimum Distributions (RMDs) that would otherwise start at age 72.
Example: The difference between pre-tax and Roth account balances available in retirement.
Scenario and assumptions: Person 1 and Person 2 each contribute $3,600 a year to a retirement plan, and they both earn 6% annually on their investments. Person 2 makes pre-tax contributions and Person 1 makes Roth contributions. After 30 years, each has $284,609 for retirement. Person 2, however, will owe taxes on the withdrawals, while Person 1’s withdrawals will be tax-free*. See Figure 1.
An Unencumbered Advantage
When contributing to traditional group 401(k) retirement plans, making after-tax contributions can be tricky, capped, or disallowed due to nondiscrimination testing. Since Self-Directed Solo 401(k) plans are designed for independent contractors and one-person business owners (including spouse and business partners) and do not include employee-participants, they are not subject to ERISA rules and testing requirements.
This keeps the contribution amount uncapped (but within the annual limit) making it one of the most advantageous ways to save and have access to a considerable amount of tax-free money in retirement. For any qualifying person who wants to maximize their after-tax contribution options and amounts, while having direct control over a diversified and personalized investment portfolio, this plan checks off more boxes than any other employer-sponsored or individual plan.