You may have never considered there could be financial advantages by making voluntary after-tax contributions to your Solo 401k. Or maybe you think that after-tax contributions are Roth contributions. While all Roth contributions are after-tax, not all after-tax contributions are Roth. We will focusing on After-Tax Contributions, but first, let’s go over the various contributions. options.
Three Types of Solo 401k Contributions
You’re allowed to make three different types of contributions to your Solo 401k:
1. Employee Deferrals:
Employee deferrals are issued before taxes. However, many plan holders have a Roth Solo 401k that have contributions after taxes are paid. It’s important not to confuse Roth contributions with after-tax contributions. Roth contributions that come directly out of your salary are employee deferrals that have an annual 401k limit.
2. Employer Contributions:
Employer contributions are the second type of contribution (aka profit-sharing contributions). These type of contributions are always pre-tax.
3. After-tax Contributions:
After-tax Contributions are not tax-deferred or Roth. They are after-tax contributions that you might overlook as a potential tax-deferred or tax-free growth. The benefit of this contribution is, it is tax-deferred. Contributions grow until withdrawals begin, even when you might be in a lower tax bracket. The best alternative is converting these after-tax contributions to a Roth account, then the future distributions become tax-free.
You can contribute after-tax dollars to your Solo 401k plan dollar for dollar, up to the total annual Solo 401k limit (for 2021 the limit is $58,000 or $64,500 if age 50-plus).
Some people don’t reach those limits. Your Solo 401k employer contribution can be 20-25% of your net profits from the business. If that, plus your employee deferral amount, does not reach the total limit ($58,000 for 2021), you can make up the difference with after-tax contributions.
A source for these funds can be a third-party workplace 401k account Once the maximum employee salary deferral contribution of $19,500 is reached for the current year, the rest of the withholdings become “after-tax”.
There is still the case of a small complexity because the after-tax contributions have tax-deferred earnings associated with them. Unfortunately, you can’t take out the after-tax contributions.
These after-tax contributions and earnings can now be added to your Solo 401k up to the annual limit. This creates an opportunity to fund a Roth Solo 401k account using a Roth conversion. This is how earnings go from tax-deferred to tax-free.
Check out: Mega Backdoor Roth Solo 401k
Making this possible is the IRS Notice 2014-54 that allows the plan to roll the after-tax funds to a Solo 401k without a plan-triggering event and then convert them to a Roth Solo 401k. You’ll then file the IRS form 1099-R to document the conversion (see the section “Distributions allocable to an in-plan Roth rollover”). No taxes are due on converting voluntary after-tax contributions to Roth.
Another option is doing this completely within your Solo 401k. Nabers Group allows for both voluntary after-tax contributions, up to 100% of your net compensation, (based on your net earnings from your business), and we allow in-plan Roth conversions. These pieces are necessary for the Mega Backdoor Roth Solo 401k strategy. The mega backdoor Roth strategy allows you to get more than the typically allowed limit of Roth funds into the plan via contributions.
The Two Distribution Limitations of a Roth Solo 401k
To be tax-free, your Roth funds need to be qualified. To qualify, the distribution needs to meet the following criteria:
- Roth funds have been in your Roth Solo 401k account for 5 years.
- You are age 59.5 or older.
You may want to make your first contributions and the Roth conversion sooner to allow for the 5-year aging requirement before distributions can begin. The good news is that the waiting period can be as little as 4 years. This is because the clock starts running on January 1 of the year, even if you make the contributions or conversion as late as December of the first year.
The good news is, you can go ahead and make a small contribution to your Roth Solo 401k now. And if you already have a Roth Solo 401k, the clock is already running.
A Brief Example
Voluntary after-tax contributions are an excellent way to get more money into your Solo 401k plan. Once the funds are in the plan and converted to Roth, the qualified tax-free distributions can also give you an edge in your wealth growth and accumulation strategy over time.
It’s advisable to consult with a financial advisor before making any decisions.