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:
- 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.