Note: opening a separate bank/brokerage account to hold the Roth solo 401k funds does not mean you are opening an additional solo 401k but rather an additional holding account under the existing self-directed solo 401k to hold the Roth solo 401k funds. The IRS refers to this additional solo 401k holding account as a Roth Designated Account.
The amount converted from the pretax solo 401k to the Roth solo 401k is considered a taxable conversion so is includible in gross income in the year of the conversion, but going forward eligible distributions from the Roth solo 401k account (including earnings) are generally tax-free. This is why the self-employed business owner must separately account for all contributions, gains and losses to this designated Roth solo 401k account until this account balance is completely distributed.
You may be considering converting your traditional (pretax) solo 401k to a Roth solo 401k (designated Roth account) in 2021. Following are key items to understand prior to proceeding.
December 31, 2022 is the Deadline
- Conversions must be processed by December 31, 2022 in order to count for 2022.
- This means that the funds and/or assets must be deposited from the solo 401k pretax bank/brokerage account to the Roth solo 401k bank/brokerage account by 12/31/2022.
- Don’t confuse the contribution deadline rules with the conversion deadline. Unlike contributions where you can make them the following year (2023) by the self-employed business tax return due date plus extension, the Roth solo 401k conversion rules require the funds and or asset converted by 12/31/2022.
- Don’t forget that your solo 401k provider may need more time than you think to complete the conversion including assisting in opening the Roth solo 401k bank or brokerage account if that has not yet been done. Waiting until the last minute can be a nail biter.
Don’t Forge About Taxes
The conversion of pretax solo 401k funds to the Roth Solo 401k designated account is considered a taxable event but not subject to the 10% early distribution penalty.
The pretax solo 401k conversion will increase your ordinary income for 2022 – potentially causing the loss of exemptions, credits tax deductions, taxation of Social Security, and increased premiums for Medicare Part B and Part D premiums – but this only happens for the year of the conversion. The trade-off is that all future qualified distributions from your Roth solo 401k will be distributed completely tax-free.
Reasons to Process a Conversion
Should you convert solo 401k funds to the Roth solo 401k bucket? Some factors in favor of converting include not needing your money soon, or even at all and expecting your future tax rates to be higher. Being younger can favor conversion as younger people generally are in a lower bracket, have not yet accumulated large sums in their solo 401k, and have long retirement savings timelines to work with.
Reasons not to Processing a Conversion
Conversion may make sense for some but is not for everyone. Why may you not want to process an in-plan solo 401k conversion? Conversion may not be for you if:
are older and will need the money soon;
you think you will be in a lower tax bracket at retirement; and
not having available, non-retirement assets to pay the tax due on the in-plan solo 401k conversion.
No Do Over
Just like Roth IRA conversions, you cannot change your mind once the in-plan solo 401k conversion has been processed. To learn more about the in-plan Roth solo 401k conversion rules, VISIT HERE.