Self-employed? Seeking to ramp up your retirement savings? You should look at the potential of the Roth Solo 401(k). If you are a high-earning solopreneur, this savings vehicle may be a great choice because it allows you to make both employee and employer contributions to a 401(k) plan in the same year, with the potential for tax-free income in the future.
How does a Roth Solo 401(k) work? Think of it as a standard Solo 401(k) with an added Roth account. The magic word is Roth. You have the chance to make tax-exempt withdrawals from this 401(k) for retirement, in the manner of a Roth IRA.
Employee and employer contributions to a standard Solo 401(k) must be made with pre-tax dollars. In the case of a Roth Solo 401(k), you make your employee contributions with after-tax dollars – they go into the plan’s Roth account. You get no immediate tax break by contributing after-tax dollars, but as a tradeoff, the contributions and earnings from the Roth account can eventually be withdrawn tax free (assuming you abide by IRS rules).
As an employee, you can defer up to $18,000 into a Roth Solo 401(k) in 2017. This amount will rise in future years, as it is indexed for inflation. Yearly catch-up contributions of up to $6,000 are also allowed for those 50 and over.
Your business may contribute a percentage of its yearly net earnings to the plan. The annual cap is 25% for incorporated businesses, 20% for LLCs and sole proprietorships. The asterisk here is that the employer contribution still has to be made with pre-tax dollars – it cannot be a Roth contribution.
Your total employer and employee contributions to the plan can be as large as $54,000 in 2017, $60,000 if you are eligible to make the aforementioned $6,000 Roth catch-up contribution. (The maximum amount of employee elective deferrals and employer non-elective contributions needs to be calculated using the methods detailed in IRS Publication 560.)
What range of investment choices do you have? Like an IRA, a Solo 401(k) is a self-directed retirement plan. That means you can invest your plan assets in myriad ways. A traditional 401(k) sponsored by a large employer typically gives you limited, garden-variety investment options.
What are the restrictions on these plans? As the name implies, they are reserved for the smallest businesses. To have any kind of Solo 401(k), you must work for yourself and have a maximum of only one other full-time employee (and that other FTE needs to be your spouse). If you foresee hiring people as your business evolves, then this is not the retirement account for you.
When the balance of your Solo 401(k) exceeds $250,000 at the end of a year, you must start to file Form 5500 annually with the IRS. Solo 401(k) plans are also subject to non-discrimination testing if you have common-law employees. (If you have an employee and you can control what will be done by that worker and how it will be done, that is a common-law employee by IRS definition.)
What if you want to participate in another employer’s 401(k) plan? You can have a Roth Solo 401(k) and do that, but if you do, keep in mind that your total employee contributions to 401(k)s for 2017 cannot exceed $18,000, $24,000 if you are 50 or older.
As you cannot deduct after-tax dollars, you cannot deduct your employee contributions to your Solo 401(k)’s Roth account. Your business, however, can still take a tax-deductible contribution for the profit-sharing contributions it makes with pre-tax dollars to your Solo 401(k) plan. In case you are wondering, participation as an employee in another 401(k) plan does not restrict the amount of the annual employer profit-sharing contribution you can make to your own plan. The 25%/20% net earnings cap still applies.
December 31 is the annual deadline. If you want to contribute to a Solo Roth 401(k) for a current tax year, you must create the plan by that date or earlier. Many self-employed people need to establish a retirement plan, and through a Solo Roth 401(k), you could go a long way toward fixing a retirement savings shortfall.