Solo 401k plans are a beacon of retirement planning flexibility for the self-employed and small business owners, offering the unique advantage of higher contribution limits and investment control. These plans not only empower individuals to take charge of their retirement savings but also adapt their strategies to align with personal financial goals and market conditions.
The enactment of the SECURE 2.0 Act further broadened options for Solo 401k plan holders by introducing the option of Roth employer contributions. This update allows for a more diverse approach to retirement savings, combining the tax-free growth benefits of Roth contributions with the robust contribution capabilities of the Solo 401k.
Understanding the SECURE 2.0 Act and Its Implications
According to legislators, the primary aim of SECURE Act and SECURE Act 2.0 is to strengthen the nation’s retirement system, making it more accessible and versatile for Americans across various employment sectors, including the self-employed and small business owners.
The SECURE 2.0 Act Overview
The SECURE 2.0 Act is a comprehensive piece of legislation that aims to revolutionize the way Americans approach retirement savings.
For instance, a provision in the Act includes a tax credit for $1500 (spread over 3 years) if your retirement plan includes Eligible Automatic Contribution Arrangement (EACA). Another provision in the Act increased the Required Minimum Distribution (RMD) age from 72 to 73 beginning Jan. 1, 2023, and bumps up to age 75 starting in 2033.
The SECURE Act 2.0 also allows for the employer to make Roth contributions into a company retirement plan.
Impact on Solo 401k Plans
By allowing for Roth employer contributions, the Act opens up a new dimension in retirement planning for self-employed individuals. Imagine Sarah, a graphic designer with her own business, who prefers the Roth option for its tax-free withdrawals in retirement.
Now, she can supercharge her retirement savings by making employer contributions to a Roth account as well, providing her with more flexibility and control over her tax situation in retirement.
The Solo 401k does not allow matching contributions, so these employer Roth contributions would be considered “non-elective” contributions.
This pivotal change enhances the attractiveness of Solo 401k plans and aligns them more closely with the diverse needs and strategies of today’s independent workers.
But how does the Roth employer contribution provision stack up against the very popular Mega Backdoor Roth?
Refresher: Types of 401k Contributions
Roth Contributions Explained
Roth contributions are characterized by their post-tax contribution nature, meaning taxes are paid upfront, allowing for tax-free growth and withdrawals in retirement. This contrasts with traditional pre-tax contributions, where tax advantages are realized upfront, and taxes are deferred until withdrawal.
Traditional vs. Roth Contributions
Within Solo 401k plans, the choice between traditional and Roth contributions hinges on individual tax situations and future income expectations. Traditional contributions reduce taxable income in the contribution year, providing immediate tax relief, whereas Roth contributions promise tax-free income in retirement, appealing to those anticipating higher future tax rates.
Steps to Implement Roth Employer Contributions in Your Solo 401k
Incorporating Roth employer contributions into a Solo 401k plan necessitates a thorough understanding of the procedural requirements and potential plan amendments.
To initiate Roth employer contributions, Solo 401k plan holders must ensure their plan documents support this feature. This may involve amending the plan to include Roth provisions, a process that should be undertaken with careful consideration and, ideally, professional guidance to ensure compliance and optimal structuring.
Reporting Requirements for Roth Employer Contributions
The SECURE 2.0 Act has introduced specific reporting nuances for Roth employer contributions that Solo 401k holders must navigate. The IRS guidance on Roth employer contributions is very new and was released on Dec. 20, 2023 (almost a full year after SECURE Act 2.0 went into effect).
Do Roth Employer Contributions Go on the W2 or 1099-R?
Solo 401k plan holders must adhere to precise reporting instructions for Roth employer contributions, delineated by recent IRS guidance. In almost all cases, the employer non-elective Roth contribution is reported on IRS form 1099-R, not the W2.
Reporting obligations for designated Roth nonelective contribution are the same as if:
- the contribution was a direct Roth 401k contribution, and
- the pretax contribution was converted in-plan to Roth as an in-plan Roth rollover.
In other words, employer Roth contributions for a Solo 401k are reported on IRS form 1099-R for the year in which the contributions are made to the individual’s account, and they are taxable to the individual.
The total amount of Roth employer contributions for that year are reported in boxes 1 and 2a of the 1099-R, and code “G” is used in box 7. This essentially means the contribution is taxable to the participant but considered an in-plan direct Roth rollover.
Tax Implications and Benefits
The tax ramifications of incorporating Roth employer contributions into Solo 401k plans present a complex landscape of immediate and deferred considerations, pivotal for optimizing retirement savings and tax strategies.
With a Roth employer contribution, the Company (your business) takes a deduction as an employee benefit expense for making the contribution to your 401k. The 401k plan then issues a 1099-R as described above so the employee (plan participant) has to pay taxes on contributed funds.
For Solo 401k account holders, your business gets the deduction on the company tax return and you personally report the income in the amount of the contribution. There is no FICA on Roth employer contributions and they are not reported on the W2.
How Beneficial Is This Really?
Does this sound familiar? If you think the mechanics work just like a pretax to Roth conversion, you’re correct. It’s the identical process and tax liability for you as the Solo 401k plan participant.
While Roth employer contributions within a Solo 401k stand out for their tax-free growth and withdrawals, one has to wonder if the work of the Roth employer contribution is worth it when compared to the mega backdoor Roth strategy, where after-tax funds are converted to Roth with no tax liability.
Furthermore, Roth employer contributions are limited to 25% of income where the voluntary after-tax contribution in a mega backdoor Roth allows 100% of income to be contributed, up to the IRS maximum.
Strategic Considerations for Choosing Roth Employer Contributions
Deciding to make Roth employer contributions within a Solo 401k involves a strategic evaluation of various factors.
The choice between Roth and traditional employer contributions should be informed by considerations such as current and anticipated future tax rates, retirement income goals, and the overall tax diversification of one’s retirement portfolio. You’ll also want to think about the value of Roth employer contributions (and the work involved) as compared with the mega backdoor Roth strategy, where you can typically put more money into a Roth account.
Long-term Planning Impact
Roth employer contributions can significantly impact long-term retirement planning, offering tax-free income in retirement. This strategic choice should align with broader financial goals and retirement visions, ensuring a cohesive and effective retirement strategy.
Common Misconceptions and Clarifications
Despite the clear advantages, there are common misconceptions surrounding Roth employer contributions that need addressing.
One prevalent misconception is the belief that Roth contributions are universally superior to traditional contributions. The reality is that the optimal choice depends on individual circumstances, including current tax rates, income levels, and retirement goals.
Future Outlook and Additional Resources
The landscape of Solo 401k plans and Roth employer contributions is subject to ongoing legislative and regulatory changes. The retirement planning domain, particularly regarding Solo 401k plans and Roth contributions, is dynamic, with potential future changes that could further enhance or alter the current frameworks and strategies.
For Solo 401k holders seeking to navigate the complexities of Roth employer contributions, a wealth of resources is available, including IRS bulletins, official notices, and professional advisory services, providing guidance and insights into effective retirement planning.
Wrap Up
Embracing Roth contributions can be a powerful component of a diversified retirement savings strategy, particularly for those seeking tax-free income in retirement. However, the decision to utilize this option should be informed by a comprehensive understanding of the associated benefits, requirements, and tax implications. And, you need to weigh the benefits of Roth employer contributions vs the mega backdoor Roth strategy.
Ultimately, the integration of Roth employer contributions into Solo 401k plans exemplifies the evolving nature of retirement planning, underscoring the importance of staying informed, adaptable, and strategic in navigating the path to financial security in retirement.
2 Responses
I’m a sole proprietor that has an existing pretax solo 401(k) that was transferred to Schwab when Schwab purchased TD Ameritrade. Schwab sent me an email a couple of weeks ago to notify me that I could open a Roth solo 401(K) as well. So I did and yesterday I sent Schwab $20K to fund the new Roth 401(k) plan. I admit that I didn’t do enough research before taking the plunge. After reading your xlnt article, I’m confused. Can I characterize my $20K contribution as an employee contribution, because it’s not a rollover and I already paid tax on that money? If Schwab issues me a 1099-R, the money will be taxed twice!
Thanks, Isaak. Sounds like you’ll need to speak with your CPA here. You may be able to characterize the contribution as a Roth employee contribution (you can certainly do that with our plan). I can’t speak for Schwab and their limitations…