Mega Back Door Roth
After-Tax Money in Employer Solo 401k Plans
The ability for a plan participant to make after tax contributions is largely up to the solo 401k plan provider. Although a solo 401k plan can allow for after-tax contributions, the solo 401k plan provider is not required to provide a retirement plan document that allows for it. Indeed many plans don’t offer this option.
While not all solo 401k plans allow for after-tax contributions, My Solo 401k Financial offers a solo 401k plan document that allows for aft-tax contributions.
One benefit of after-tax contributions is that the salary deferral limits that apply to other participant contributions do not necessarily apply to after-tax contributions. In 2017, the combined salary deferral limit for pre-tax and Roth salary deferrals to Solo 401(k) plans is $18,000. If solo 401k participants are 50 or older by the end of the year, then they can contribute an additional $6,000, for a total of $24,000. If, however, they are eligible to make after-tax contributions to a solo 401k plan, those contributions are not subject to these limits. In addition to the $18,000/$24,000 limit on salary deferrals (also known as employee contributions), there is a lesser known rule called the “overall limit.” The overall limit for 401(k) plans including solo 401k plans for 2017 is $54,000, or 100% of compensation, whichever is less. The overall limit looks at the total annual additions to all of a participant’s accounts in plans maintained by one employer, and includes not just their salary deferrals, but also matching contributions, allocations of forfeitures and other amounts.
If a solo 401k provider’s plan document allows for after-tax contributions, then-from a tax code perspective-the self-employed individuals can make such contributions up to their overall limit for the year.
Liz works for an employer that sponsors a full-time employer 401(k) plan that allows her to make after-tax contributions. She plans on making a full $18,000 deferral to her Roth 401(k) and expects to receive, between matching and profit-sharing contributions, another $10,000 in employer contributions. That would give Liz a total of $28,000 of additions to her plan for 2017. As such, assuming Liz has enough compensation to do so, she can contribute an additional $26,000 in after tax funds to her plan ($54,000 overall limit – $28,000 of other deductions) for 2017.
Let’s assume the same as example 1 above except that Liz is also self-employed on the side and thus opens a solo 401k plan that allows for after-tax contributions. Therefore, Liz is participating in two separate plans (the full-time employer 401k and her own solo 401k plan sponsored by her self-employed business). Therefore, using the same numbers as example 1 above, Liz can make the $26,000 after-tax contribution to her Solo 401k plan provided, of course, she has enough earned income from her self-employed business to make the after-tax contribution.
How can I get more money into my Solo 401k from my full-time employer 401k, 403b or 457b?
In addition to having different rules than pre-tax and Roth salary deferrals on their way in to a plan, after tax contributions also have different rules for how they may come out the plan. The plan distribution rules are complicated but, for the most part, if a 401k, 403b or 457b participant is still working for the company sponsoring their plan and they are under 59 ½, access to their pre-tax salary deferrals, Roth salary deferrals and their earnings is largely limited. However, once a participant leaves their job or turns 59 ½, that changes.
Great News, However
The same restrictions, however, do not apply to after tax contributions and their earnings, provided that they are maintained by a plan in a separate account. These funds may be fairly accessible, depending on a plan’s rules, even if a client is under 59 ½ and still working for the company offering their 401k, 403b or 457b. If their plan allows, they may be able to take a distribution of these funds at any time via “in-service distributions.” Being able to take-out the after-tax distributions from the plan opens the door to the following strategy.
The “Mega Back Door Roth Solo 401k”
The ability for a full-time employer plan participant to take a distribution of their after-tax contributions, including earnings, even before they reach age 59 1/2, opens the door to a strategy dubbed by some as the “mega back-door Roth Solo 401k.” In order for a client to take advantage of the mega-back-door Solo 401k Roth strategy, the following conditions must be present:
- The business owner’s solo 401k plan must allow them to make after-tax contributions.
- The business owner must have enough earned income from self-employment to make the after-tax contributions to their solo 401kplan.
- The Solo 401k plan must allow for in-plan Roth Solo 401k conversions.
Thanks to ATRA (the American Taxpayer Relief Act of 2012), which liberalized the conditions for executing in-plan Roth Solo 401k conversions, solo 401k participants can process in-plan conversions of all solo 401k funds. Before ATRA, in-plan Roth Solo 401k conversion were available to solo 401k participants only when a participant had satisfied a statutory or regulatory distribution trigger and as permitted by the solo 401k plan. For example, solo 401k plan deferrals generally are unavailable for distribution before a participant reaches age 59½. As a result, only at age 59½ or later could an in-plan Roth Solo 401k conversion of elective deferrals take place. ATRA changes this and permits an in-plan Roth Solo 401k conversion without the requirement that a participant have a statutory or regulatory distribution trigger if the plan language permits. So now, a solo 401k plan could permit participants under age 59½ to conduct an in-plan Roth Solo 401k conversion of deferrals.
As a result, a solo 401k participant can make after-tax contributions to their solo 401k plan on an ongoing basis. Subsequently, from a tax planning perspective, before there are large gains on those amounts, they can process an in-plan Roth solo 401k conversion of those funds and deposit the funds in the Solo 401k Roth designated account. Therefore, the converted funds will be all or mostly after-tax money, and the conversion will be virtually tax-free.
Income that can be Used QUESTION:
Good question. Just like pretax contributions can only be made based on net self-employment income, the same rules apply to after tax contributions–that is, after-tax contributions are also based on net self-employment income from the business that sponsors the solo 401k plan.
Convert After-Tax Funds to Roth Solo 401k Instead of Roth IRA QUESTION:
Yes you can also choose to convert the after-tax voluntary contributions to the ROTH Solo 401k (Roth Designate Account) instead of converting them to a Roth IRA. Per the following IRS website: https://www.irs.gov/retirement-plans/retirement-plans-faqs-on-designated-roth-accounts#irr you can convert the following types of funds to a Roth 401k:
- elective deferrals,
- matching contributions (including qualified matching contributions),
- nonelective contributions (including qualified nonelective contributions),
- rollover contributions,
- after-tax employee contributions and
- earnings on the above contributions.
1099-R Nontaxable QUESTION:
Correct as long as the basis is converted right away. If earning accumulate while in the after tax account, those will be subject to taxes.
It is best to convert the after-tax funds to the Roth IRA or Roth Solo 401k as soon as a contribution is made; otherwise, the gains on the after-tax account will be subject to taxes when converted.
Which Sub Account QUESTION:
Pro-rata Rule QUESTION:
- 72(d)(2) allows for separate accounting
- Per IRS Notice 2014-54 the pro-rata rule applies at the account level