On May 18, 2016 the IRS issued final regulations on how pretax amounts must be allocated when distributions are taken from Roth Solo 401(k)s. [TD 9769] These regulations finalize the details on the taxation of various transactions when a solo 401k participant takes a distribution from their Solo Roth 401(k) that contains both pre-tax and after-tax funds.
When it comes time for these clients to take a distribution from their Roth Solo 401(k), the IRS has now ensured that the same favorable rules for allocating pre-tax assets that exist for their self-employed solo 401k plan funds will apply to their Roth solo 401(k) funds as well.
Designated Roth Accounts
The finalization of the rules governing allocation of pretax amounts when a distribution is taken from Roth Solo 401(k)s provides clarity from a distribution planning perspective for solo 401k owners. As Roth solo 401k plans continue to explode in popularity, this new Roth solo 401k regulation is welcomed with open arms. Solo 401k providers can expect to see both more solo 401k clients looking for a solo 401k with a Roth option Roth option and more clients with funds in former employer Roth 401(k)s, which may potentially be rolled over to a Roth solo 401k or Roth IRA at some point.
To understand the new regulations, you must know the basics of how Roth Solo 401(k)s work. With a Roth Solo 401(k), the self-employed individual adopts a solo 401k plan that allows for after-tax salary deferral contributions to a separate designated Roth account in the solo 401k 401(k) retirement plan. The contribution limits are the same as the salary deferral contribution limits for the employer plan. Unlike pre-tax elective deferrals, the amount the self-employed individual defers to a designated Roth account is includible in gross income. Distributions from Roth Solo 401(k)s can be rolled over to other Roth 401(k)s or to Roth IRAs. Rollovers to traditional IRAs and recharacterizations back to 401(k)s are not permitted.
A qualified distribution from a Roth Solo 401(k) is not subject to taxes or penalties. The distribution is qualified if the Roth solo 401(k) is held for more than five years and the employee has reached age 59½, or is disabled or deceased. A qualified distribution is considered to consist entirely of basis. When these funds are transferred to another employer’s Roth 401(k) or to an individual Roth IRA, they go into the new account as basis and are available for distribution income tax free. The final regulations will not matter for qualified distributions from Roth solo 401(k)s. Why? Well, allocating pretax assets is not an issue when the distribution is a qualified distribution because the entire distribution is tax-free.
Example: Jane has a Roth solo 401(k) as part of her self-employed business 401(k) plan. She has been making deferrals to this Roth solo 401k account since it first became available in 2010. She now has a balance in the Roth Solo 401(k) of $80,000, $65,000 of after-tax deferrals and $15,000 of earnings. Jane decides to retire at age 63 and takes a full distribution of her Roth solo 401(k). Because Jane is over age 59½ and has participated in the Roth solo 401(k) for more than five years, her distribution is a qualified distribution and Jane will owe no income tax on the $75,000 distribution.
Things get more murky when a distribution is a nonqualified distribution. When the solo 401k owner takes a nonqualified distribution from their Roth solo 401(k), their after-tax deferrals and any converted amounts are distributed tax-free. However, a nonqualified distribution of earnings is taxable. This is why the final regulations on allocation of taxable amounts will matter for nonqualified Roth solo 401(k) distributions.
Pro-Rata Rule Applies
A distribution that is not a qualified distribution is subject to the pro-rata rule. A portion of every distribution taken will be considered taxable and a portion will be considered nontaxable. The non-taxable amount of the distribution is generally determined by dividing the employee’s deferrals (basis) by the balance in the Roth solo 401(k) account and multiplying the amount distributed by the result. Unfortunately, the favorable ordering rules used to determine the taxation of a distribution from a Roth IRA do not apply to Roth 401(k)s.
Example: Fred has deferred a total of $30,000 to his Roth Solo 401(k) and has a total balance in the account of $40,000. He then takes a nonqualified distribution of $12,000. $9,000 of the distribution will be tax free. ($30,000 / $40,000 = .75) ($12,000 x .75 = $9,000).
Final Regulations Apply Rules from Notice 2014-54
The final regulations apply the rules from Notice 2014- 54 to Roth Solo 401(k)s. They confirm that if a solo 401k participant takes a nonqualified distribution from their Roth Solo 401(k) that the pre-tax portions are allocated first to direct rollovers, then to 60-day rollovers and finally, to amounts not rolled over rather than being allocated pro-rata to each destination.
Example: Fred has deferred a total of $30,000 to his Roth Solo 401(k) and has a total balance in the account of $40,000. He takes a nonqualified distribution of $12,000. $9,000 of the distribution will be tax free and $3,000 will be taxable. If Fred decides to directly roll over $3,000 to his Roth IRA and chooses to have $9,000 paid to him, the taxable portion of the distribution will be allocated to the $3,000 he directly rolls over to his Roth IRA. The $9,000 distribution paid to him will be tax-free.
The final regulations also confirm that a solo 401k owner can direct the allocation of pre-tax and after-tax amounts included in disbursements from a Roth solo 401(k) that are rolled over to multiple destinations. Notice 2014-54 gives this same option to clients with other employer plan funds that are not in Roth solo 401(k)s. A client can direct the pre-tax portions of a solo 401(k) distribution to a traditional IRA rollover, while at the same time, allocating the after-tax portion of a distribution to a Roth IRA conversion. By doing so, they are able to retain the tax-deferred status on the pre-tax portions of their distributions and simultaneously convert only the after-tax portions of their plan distributions to a Roth IRA, tax-free.
For Roth Solo 401(k)s, the ability of the solo 401k owner to direct the funds is much less important than for other employer plan funds. Why? Well, distributions from Roth solo 401(k)s may not be rolled over to traditional IRAs. Distributions from Roth Solo 401(k)s can only be rolled over to a Roth IRA or another Roth 401(k).
Example: Jane has deferred a total of $30,000 to her Roth solo 401(k) and has a total balance in the account of $40,000. She takes a nonqualified distribution of $12,000. $9,000 of the distribution will be tax free and $3,000 will be taxable. If Jane decides to directly roll over $6,000 to her Roth IRA and directly roll over $6,000 to her new employer’s Roth 401(k), she can allocate which rollover will include the $3,000 pre-tax amount.
For many clients there will not be multiple destinations for the rollover of their Roth solo 401(k) funds. They will roll over the distribution to their Roth IRA. The favorable ordering rules that govern Roth IRAs will allow them to access their basis tax and penalty free as the first funds out of the Roth IRA.
Example: Jane is moving the total balance in her Roth Solo 401(k). This is a nonqualified distribution. She requests a direct rollover of the total amount to her Roth IRA ($40,000, $30,000 of deferrals and $10,000 in earnings). The total amount will go to her Roth IRA. The taxability of any future distribution of these funds will now be determined by the Roth IRA ordering rules.
The final regulations are effective on May 18, 2016. They generally apply to distributions on or after January 1, 2016. A solo 401k owner can choose to apply them to any distribution taken on or after September 18, 2014.
The final regulations provide certainty that favorable rules for allocating any pretax amounts disbursed from a Roth Solo 401(k) will be available when the time comes to process a distribution.