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Mega backdoor Roth within the Solo 401k

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What it is

The mega backdoor Roth strategy is a way to get more Roth funds into your retirement account. Roth funds are taxed initially but grow tax-free.

The mega backdoor Roth strategy consists of:

  • Making after-tax contributions to the Solo 401k, and
  • Converting those after-tax contributions to Roth within the Solo 401k, and
  • Keeping those Roth funds in the Solo 401k for checkbook-control investing or rolling over the funds into a Roth IRA

The Mega Backdoor Roth strategy offers an alternative to contributing to a Roth IRA directly, which is limited to $6,500 per year by the IRS. Many individuals also do not qualify for a Roth IRA due to their high earnings.   

Your Solo 401k with Sense Financial already includes the features which allow you to utilize the mega backdoor Roth strategy.

How it works

  • Open separate accounts for your Solo 401k to house your after-tax contributions and Roth funds, if you do not have these already

From a banking standpoint, these separate accounts will be identical. Both are in the name of your 401k and using the EIN of your 401k. However, these accounts are established to keep the funds separate from each other and to assist you in your accounting of each type of fund within your 401k. You can assign nicknames to the separate accounts online in order to differentiate them.

  • Calculate the after-tax contribution based on your self-employment business earnings
  • Make the after-tax contribution into the 401k account for after-tax contributions
  • Once that after-tax contribution is in your 401k, immediately convert the funds to Roth and move those funds to the Roth account

Note that the growth on the after-tax contribution is taxable, so you will want to convert the after-tax contribution to Roth immediately after the contribution is made.

  • Keep those funds within the Roth account of your Solo 401k for checkbook-control investing or roll those funds over to a Roth IRA
  • The following year, file a 1099-R to document the conversion

How it should be reflected on a 1099-R

In this case, the 1099-R should document the conversion of the after-tax contribution to Roth within your 401k. The Payer is your 401k trust, which is issuing the 1099-R to you, the Recipient.

  • Payer: your 401k trust
  • Payer TIN: the EIN of your 401k trust (not the EIN of your adopting business)
  • Recipient TIN: your SSN
  • Recipient: you, as an individual
  • Box 1: Gross distribution: amount that was converted to Roth
  • Box 2a: Taxable amount: 0.00 if the after-tax funds were converted to Roth immediately. The taxable amount would be 0.00 since the after-tax contribution was not originally claimed as a deduction and was converted to Roth immediately. If the after-tax contribution was not converted to Roth immediately, the growth amount is taxable and should be entered here.
  • Box 5: Employee contributions/Designated Roth contributions or insurance premiums: amount of the original after-tax contribution. If you converted the after-tax contribution to Roth immediately after making the contribution, this should be the same amount as in Box 1
  • Box 7: Distribution code: G which indicates a direct rollover (from after-tax to Roth) within the plan, your 401k

When the 1099-R should be filed

The 1099-R is filed in the year following the year in which the Roth conversion was performed (e.g. the 1099-R for 2022 is filed in 2023). There are two deadlines for the 1099-R:

  • The Payee/recipient copy must be received by January 31st
  • The electronic copy must be filed with the IRS by March 31st

You are responsible for the filing of the 1099-R by both deadlines.

Sense Financial can assist with the filing of the 1099-R by request only, provided that we receive your request by our deadline of the second Monday in January.

Planning for contributions

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The end of the year is approaching, and with it, the opportunity to make contributions to your Solo 401k.  

A few simple steps can help you prepare:

1. Budget time to read a few articles or videos

Set aside an hour or two this weekend to read or watch our contribution resources. We have plenty of resources to help you.

The following overview addresses how to calculate, how to make, and when to make contributions:

Contribution basics

The following video gives an overview on calculating contributions:

Understanding contributions goes a long way in helping you feel prepared. Setting aside the time to read and watch the above is an easy first step.

2. Mark the deadline for your contributions on your calendar

Different factors affect the deadlines for your Solo 401k contributions. The deadline can differ based on the type of contribution you are making, the type of business you have, and the fiscal year of your business.

https://www.sensefinancial.com/solo401k/solo-401k-contribution/

Make sure to mark the deadline(s) for these contributions on your calendar, so you have plenty of time to prepare and make them for this year.

3. Do some initial calculations

Your Solo 401k allows you to make different types of contributions- as employee and as employer.

The employee and employer contributions differ in how they are calculated. Factors such as: how much your business earnings/compensation for the year, your current age, and your participation in other employer-sponsored plans can affect the contribution amounts to your Solo 401k.

Start by grabbing a pencil and paper and input a few numbers to come up with some initial calculations:

https://www.sensefinancial.com/solo401k/solo-401k-plan-calculator/

4. Confirm your calculations with your CPA

Your CPA can confirm both your business earnings/compensation for the year, which serves as the basis for your contributions, and the contribution amounts you can make to your Solo 401k.

5. Prepare for your contributions

Solo 401k contributions must be documented and, depending on your type of business, processed a certain way.

  • Documentation

All contributions must be documented using our contribution forms. These forms document the election to make the contribution and must be dated by December 31st of the year for which the contribution is made. The completed and signed contribution form must be kept in your file as Plan Administrator of your Solo 401k.

Forms to Administer Solo 401k Plan
  • Processing

If you have a corporation or an LLC with an S-corp election, you will need to notify your payroll provider of your planned Solo 401k employee contribution. Your Solo 401k employee contribution must be processed through payroll. This typically occurs before the end of December, and the payroll provider must be notified and given time to process your employee contribution.

Contributions from my corporation
6. Make your contributions

After-tax contributions

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The Solo 401k allows you to contribute to your plan in two ways- as employee and employer. Within the category of employee contribution, there are three types:

  • Pre-tax
  • Roth
  • Voluntary After-tax

Defining the three types of employee contributions

  • A pre-tax employee contribution is taken from compensation earned and reduces the taxable income. If you made a pre-tax employee contribution, you would deduct the amount of that contribution on your tax return.
  • A Roth employee contribution is taken from compensation earned and does not reduce the taxable income. If you made a Roth employee contribution, you would pay taxes at the time of the contribution.
  • A voluntary after-tax employee contribution is taken from compensation earned and does not reduce the taxable income. If you made a voluntary after-tax employee contribution, you would pay taxes at the time of the contribution.

What are the differences between them?

There are two main differences between these three types of employee contributions- how the distribution is taxed and the maximum limit of the contribution.

  • How the distribution is taxed

When a pre-tax employee contribution is distributed, both the principal amount of the contribution and its growth is taxed at the current rate at the time of distribution.

A Roth employee contribution and an after-tax contribution is a qualified distribution when you are age 59.5 and older and the funds have been in the 401k for 5 years or longer.

With both a Roth employee contribution and an after-tax contribution, the principal contribution amount is not taxed upon distribution. However, the two contributions differ in whether the growth is taxed.

When a Roth employee contribution is distributed, both the principal contribution amount and the growth are distributed tax-free.

When an after-tax employee contribution is distributed, only the principal contribution amount is distributed tax-free. The growth is taxable and must be taxed at the current rate at the time of distribution.

  • Maximum limit of the contribution(s)

Both a pre-tax and a Roth employee contribution is subject to a combined maximum limit:  $20,500 plus $6,500 catchup (for those age 50 and above) for 2022. In other words, you can make pre-tax contributions, Roth contributions, or a combination of both, but the combined total cannot exceed the maximum limit for the year.

An after-tax employee contribution is subject to a different maximum limit:  $61,000 for 2022.

Making an after-tax contribution

Your Solo 401k plan now includes the ability to make after-tax contributions.  All three types of employee contributions are documented in the Post PPA version of your Adoption Agreement.

If making an after-tax contribution, you will first want to establish a separate account for the contribution(s).  Because an after-tax contribution is different from a Roth contribution, the after-tax contribution should not be kept in the same account as a Roth contribution.

Once the after-tax contribution is made to its own account, the funds can then be converted to Roth within your 401k as part of a mega backdoor Roth strategy. Due to the tax consequences of the mega backdoor Roth strategy, you will want to check with your CPA first before undertaking the strategy.

Reporting CARES Act distributions and repayments

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The IRS has released Form 8915-E and 8915-F for the reporting of CARES Act distribution(s) that were taken in 2020, their repayment, or their inclusion in income.

If you took a CARES Act distribution in 2020, note which form(s) would apply to you:

Form 8915-E is used to report:

  • If you took a CARES Act distribution in 2020

Form 8915-F is used to report:

  • Your income in 2021 if you took a CARES Act distribution in 2020 and have been including in your income in equal amounts over 3 years and that 3-year period has not yet lapsed
  • Your repayments of a CARES Act distribution, if repaying the distribution

Note that repayment of the CARES Act distribution can be done over 3 years, starting with the day after the distribution was received. Repayment(s) can occur through multiple payments or one lump sum payment by the end of those 3 years. If the entire CARES Act distribution is paid back within that time, the distribution will not be taxed.

You will want to request your CPA’s assistance in completing the appropriate form for your situation. 

More information on these two forms can also be found at:

https://www.irs.gov/forms-pubs/about-form-8915-e

https://www.irs.gov/forms-pubs/about-form-8915-f-qualified-disaster-retirement-plan-distributions-and-repayments

Ryan Pineda

Dmitriy’s interview on The Ryan Pineda Show

On today’s podcast, Ryan had Dmitriy Fomichenko as a guest. Dmitriy is a specialist in Solo 401Ks, and we talked all about that and why it is such a great retirement vehicle for you. We also go in depth on the differences between Solo 401Ks and SEP IRAs, as well as life insurance and the whole infinite banking concept. It’s really cool and I don’t think ever really talked about retirement on any of my channels, so for those of you wondering how you can have some tax savings or how you can put some money away, it’s a great episode and you definitely want to watch all the way through!

Watch HERE

2022 contribution limits updates

The IRS announced updates to 401K contribution limits for the 2022 tax year. While individual IRA limits were not increased, individuals with a Solo 401K have the ability to contribute more. The increases are some of the largest we have seen in many years.

2022 Solo 401K Contribution Limits

The plan maximum for a Solo 401K was increased from $58,000 to $61,000.

For those age 50 and older, the $6,500 catch up provision means a total of $67,500 can be set aside.

The employee deferral portion of Solo 401K contributions was increased from $19,500 to $20,500.

For purposes of employer profit sharing calculations, the employee compensation limit is now $305,500, up from $290,000.

Hands off my IRA

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Many Americans keep their wealth, or a large portion of it, in their retirement account. It’s a great way to build your retirement “nest egg” in a tax-deferred vehicle, and if you make wise investment choice, allow your investment returns compound, keeping the money moving, you can reach retirement with millions. It’s been my honor to help our clients unlock their retirement accounts and give them the ability to invest in alternative assets.

There is a proposed law that could have a massive, adverse impact on self-directed IRAs and 401ks. This legislation would seek to prohibit investments made from IRAs and other retirement vehicles into private placements, drastically reducing investors’ ability to diversify into other asset classes outside of the stock market. As the bill is currently worded, it would force investors to liquidate these types of private holdings inside retirement accounts within the next 2 years, triggering a taxable event, or face their full retirement account being stripped of its tax- deferred status. 

Even if it does not directly affect you, please GET INVOLVED! Tax attorney, John Hyre, has dug into the bill and shared his thoughts here. He provides a very good breakdown of the bill and ways to take action.

https://www.handsoffmyira.com/

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