Both the Roth and Traditional Solo 401k offer tax advantages when you contribute a part of or all of your self-employment salary into one of these retirement accounts. Both provide you with the ability to invest and compound the earnings as long as the funds remain in your retirement account. Nabers Group offers both types within your single Solo 401k account so that you can contribute to both each year or change your preference from one year to the next.
When you participate in a Traditional Solo 401k plan, the taxable salary that you report to the IRS is reduced by the amount that you defer to your account. This means income taxes on that money are postponed until you withdraw them from your account, usually after you retire.
When you participate in a Roth Solo 401k, the amount you contribute doesn’t reduce your taxable income or your current income taxes. However, when you withdraw after you retire, the amounts you take out are tax-free, provided you’re at least 59½ and your account has been open for at least five years. This means that all of the earnings you accumulate over the years are completely tax-free.
Which is Right for You?
Our Solo 401k plans are about maximum flexibility. Regarding Roth and Traditional Solo 401ks, one size does not fit all. The right answer for you depends on your current tax situation and whether your tax rate is likely to be higher or lower in retirement.
Because you don’t pay any taxes on Roth withdrawals, the higher your tax bracket in retirement, the more advantageous a Roth Solo 401k is likely to be. Robust savers, such as those who contribute the maximum amount allowed by the IRS each year, are top Roth candidates. This is because they are likely to take larger annual distributions in retirement that will benefit from Roth’s tax-free withdrawals.
Another Roth Solo 401k opportunity exists if you are in a low tax bracket today. The amount of taxes that you pay on contributions today is likely to be less than the tax rate you will pay on traditional distributions during retirement when you may be in a higher tax bracket.
If you’re more concerned about your paycheck today than during retirement, the Traditional Solo 401k is probably the right choice for you. Because Roth contributions are included in this year’s income, you’ll pay taxes on them. Without the deduction, it may push you into a higher tax bracket for the year. The result could be that Roth Solo 401k contributions reduce your take-home pay by more than a similar contribution to a Traditional Solo 401k. If you want to save — and take home as much money as possible — a Traditional Solo 401k is perhaps the way to go.
A third option is contributing to both a Roth and Traditional Solo 401k during the same year. Since no one knows what tax rates will be in the future, diversifying with contributions to both might be a way to hedge your tax bets with your retirement savings. The high contribution limits allowed with both types of Solo 401k accounts make this a very feasible strategy.
Understanding the Differences in Retirement Distributions
You might be asking yourself, why would anyone choose a Solo Roth 401k if it means paying more taxes now and taking home a smaller paycheck? That is a fair question if you are only thinking about the years when you will be making contributions to your retirement account. The huge Roth benefit kicks in when you start taking money out during retirement — and goes on for every year that you withdraw money from your retirement account. That could go on for many years because you will have much more money available when you don’t have to pay taxes on it.
With a Roth Solo 401k, you’ve already paid taxes on your contributions, and all the earnings are tax-free. All of the money in your retirement account is 100% yours. Uncle Sam doesn’t want a nickel of it. That means if you have invested wisely and have grown your account to $5 million, the entire $5 million is yours to spend as you want.
There are other benefits to tax-free Roth income. Roth distributions do not count towards determining the taxability of your Social Security benefit. And there are Medicare premiums to consider. Your income determines the monthly premium you’ll pay for Medicare. This isn’t just a few pennies. The difference could be hundreds of dollars per month! Distributions from Traditional Solo 401ks, IRAs, and pensions count towards that calculation. Roth Solo 401k distributions do not.
Again, this is about paying taxes now on Roth contributions or paying taxes during retirement on Traditional Solo 401k contributions. With a traditional Solo 401k, you’ll have to pay taxes on the amount you withdraw based on your current tax rate in retirement. Depending on your tax bracket and what the tax rates are when you retire, you could wind up sending hundreds of thousands of dollars in taxes to Uncle Sam throughout your golden years. That’s a hard pill to swallow, especially after you’ve worked so hard to build your nest egg!
Saving on your taxes today and bringing home a bigger paycheck might be right for you now. But your retirement savings will last longer if you’re not paying taxes on your withdrawals. That’s what gives a Roth Solo 401k a huge advantage over a Traditional Solo 401k account!
Good Reasons to Contribute to Both a Roth and Traditional 401k
You can split your annual contributions between your Roth and Traditional Solo 401k accounts, but your combined contributions can’t exceed the income deferral limit – $20,500 in 2022 (or $27,500 if over age 50). But you can also include your self-employed matching funds to boost these amounts up to as much as $61,000 (or $67,500 if over age 50).
Let’s start with a financial strategy during your retirement that allows you to take out tax-free money during big spending years and the opposite during normal or low spending years. Planning for your retirement involves balancing what you’re willing to set aside now with what you’ll pay in taxes while in retirement later.
Another reason to split your contributions is that no one knows what is going to happen with tax rates or your income between now and your retirement, and those things can make a substantial difference down the line.
Young people expect to grow in their careers over several decades. They have expectations that they will become higher earners and subject to a higher tax bracket. In that case, it can be advantageous to put money in a Roth Solo 401k when you are younger and your tax bracket is lower. You will have a longer time horizon for your contributions to grow tax-free. In later years, as you reach higher tax brackets, you may want to switch to the tax-deferred benefit that comes with the Traditional Solo 401k.
If you are in your 40s, 50s, or even 60s, you may want to at least keep the Roth Solo 401k option available. Remember, you can withdraw from a Roth as early as 59½. The only caveat is that five years must pass since your first contribution before you can withdraw the earnings tax-free. For that reason, you may want to put as little as 1% into a Roth account just to start the five-year clock.
There is another strategy that people with both types of accounts use in retirement. Some people are using combined Roth and Traditional Solo 401k accounts to manage their income tax bracket. They may pull some money out of the tax-deferred fund, and anything needed beyond a certain amount, they’ll pull out of their Roth to avoid moving up to the next income bracket. With something like a 50/50 split, you can maximize your tax diversification strategy. Even if you don’t know what tax bracket you’ll be in after you retire, you have the best of both worlds.
But remember, you don’t have to make a final decision between a Solo 401k and a Roth Solo 401k today. With a Nabers Group Solo 401k, you have both types of accounts and can make contributions to either at any time.
Mega Backdoor Roth Solo 401k
If you like the idea of a Roth Solo 401k, then you’re going to love the supersized version — known as a Mega Backdoor Roth 401k. A Mega Backdoor Roth is a strategy to put away as much Roth money as you legally can in one given year. It doesn’t matter how old you are, and there is no phase-out or income limit.
However, be forewarned, The process will require some strategy and planning with your tax professional. Creating a Mega Backdoor Roth is complicated, with many moving parts and the potential to get hit with unexpected tax bills, so consult with a financial planner or tax pro before pulling the trigger.
This strategy lets you contribute to a Roth at ANY age and income level. In 2022 the Mega Backdoor Roth can be up to these amounts:
- $67,000 if under age 50
- $74,500 if 50 or older
Maybe you thought a Roth Solo 401k employee contribution was limited to $20,500 (or $27,000 for those over age 50) in 2022. But a Mega Backdoor Roth 401k can raise that level significantly higher.
Because there are many moving parts, it can get confusing explaining one way to make this work, so we’ll keep it simple, and you’ll need to work with a tax professional to determine what works best for your situation. The process works similarly to converting a Traditional Solo 401k to a Roth Solo 401k. However, with a Mega Backdoor Roth Solo 401k, you can eliminate or significantly lower the tax liability on the conversion.
Your Traditional Solo 401k must permit after-tax contributions and in-service withdrawals. You first make an after-tax contribution to a Traditional Solo IRA that you then convert to a Roth. You have until December 31 each year to convert as much as you want (up to the limits). However, you first have to convert ANY other Traditional Solo IRA money to Roth before you can convert the contribution you just made.
Next, to build that “Mega Backdoor Roth,” you must max out your annual contributions to your Roth 401k.
Then you make an after-tax employee contribution to your Roth Solo 401k. This is where things get a little dicey. The math involves subtracting what ‘you’ contributed as an employee and the employer match from the total allowed contribution to determine the amount of ‘after-tax’ contribution.
This is where the in-service withdrawal comes into the Mega Backdoor Roth process. You immediately take an in-service withdrawal before the contributions generate returns that would be taxable during a rollover to a Roth. The “withdrawal” is essentially transferred to a Roth Solo 401k as a ‘conversion’. No tax is due, but of course, you didn’t receive a deduction either with the contribution in the first place.
If you want to build wealth, you have to plan for it. According to The National Study of Millionaires, 3 out of 4 millionaires (75%) said that regular, consistent investing over a long period is the reason for their success. Regardless of where their income comes from, they actually save money and invest!