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Roth Solo 401k

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.

Performing a Roth conversion

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IMPORTANT:  Before performing a Roth conversion, please make sure to educate yourself on the mechanics and consequences of Roth conversions.  This is a taxable event.  We always recommend that clients speak with their accountant prior to performing a Roth conversion in order to understand the tax consequences.

For information on Roth conversions, we have several articles located in our Knowledge Base regarding the Roth; please see HERE and HERE.

If you would like to perform a Roth conversion, you will need to do the following:

  • Complete the In Plan Roth Conversion form, located HERE under Miscellaneous Forms.

As Plan Administrator, you will need to keep the original as part of your recordkeeping.

  • Report the Roth conversion through Form 1099-R.  The Roth conversion will be included as part of this year's taxable income.

If you would like us to assist you in creating a 1099-R, please contact us at the beginning of the following year to request this service.  We will need a copy of your completed In Plan Roth Conversion form in order to have a 1099-R issued by your Solo 401k.

Note that you are not able to rollover funds from your previous pre-tax account(s) directly into the Roth bracket.  If you decide to do the conversion, you will first have to move those funds into the pre-tax portion of your Solo 401k, and then do the conversion and move the funds into the Roth.

Finally, we do recommend keeping the pre-tax and Roth funds separate by opening two separate bank accounts.  This is for ease of accounting.

Recharacterization of Roth conversion

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Last December, my accountant grossly miscalculated my tax liability estimate, which led me to believe that a Roth conversion could be made with a manageable tax impact. Later, when she prepared my tax returns in April, I discovered that my tax liability was actually much higher, and that the tax impact of the Roth conversion was too great to make it worthwhile. Can the Roth conversion can be reversed through timely recharacterization within my Solo 401k plan?

Answer:

No.  You cannot undo the Roth conversion.

The "Participant's Election" section of the In-plan Roth Conversion Amendment states that the in-plan Roth conversion is irreversible and cannot be undone or recharacterized in any manner.  To not follow the terms of the plan (as stated in the amendment) would be an operational failure of the plan.

The Internal Revenue Bulletin: 2010-51 published December 20, 2010 (also listed as Notice 2010-84) provides Guidance on In-Plan Roth Rollovers:

https://www.irs.gov/irb/2010-51_IRB/ar11.html

In the Question/Answer section, it states the following:

Q-6. If a participant elects an in-plan Roth rollover, can he or she later unwind the in-plan Roth rollover, as can be done with rollovers to Roth IRAs?

A-6. No. The recharacterization rule in § 408A(d)(6) applies only to contributions to IRAs.

There is no way to reverse the Roth conversion.  You will have to declare that as your taxable income and pay the taxes. Please consult with your CPA for details.

Converting property in 401k to Roth

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My Solo 401k Trust owns a rental property.  If I determine that it is better to pay the taxes on the value in the 401k now, could I convert the property and other cash in the account into a Roth 401k without selling and liquidating the property?

Answer:

You can convert property and other assets in your 401k into Roth. This will be taxable event so I strongly suggest you discuss this with your CPA.

For a Roth conversion of property, you must use a licensed third party appraisal to determine the accurate value of the property.  The appraisal must be dated as close as possible to the taxable event.

You will then need to complete a Roth Conversion form (located in Miscellaneous Forms). Your 401k will need to issue a 1099-R Form to you in the year following the conversion, and you will have to declare that as taxable income on your tax return.