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 2018, the combined salary deferral limit for pre-tax and Roth salary deferrals to Solo 401(k) plans is $18,500. In 2019, the combined limit increased by $500 to $19,000. There is a lesser known rule called the “overall 415 limit.” The overall 415 limit for 401(k) plans including solo 401k plans for 2018 is $55,000, or 100% of compensation, whichever is less. For the 2019, the overall limit is $56,000. 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 voluntary after-tax solo 401k 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 $18,500 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 $28,500 of additions to her plan for 2018. As such, assuming Liz has enough compensation, she can contribute an additional $26,500 in after tax funds to her day-time job 401k plan ($55,000 overall limit – $28,500 of other deductions) for 2018.
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 $26,500 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.
Difference Between Roth Solo 401k and Voluntary After-Tax Contributions QUESTION:
We actually have a good blog post that covers this topic which can be viewed by VISITING HERE.
60-Day Rollover Distribution of After-Tax Funds QUESTION:
Reporting Gains on Voluntary After-Tax Funds Conversion QUESTION:
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.
Tax Topic 413 QUESTION:
Good question regarding ax topic 413 (https://www.irs.gov/taxtopics/tc413). That section deals with taxable distributions. In other words, when after-tax funds are converted to the Rot IRA, it is processed as a direct-rollover not as a distribution (i.e., the check is not made payable in the name of the individual, so the typical distribution code of 1 or 7 is not used on Form 1099-R; rather a code “G” is used in box 7.). The direct-rollover check is instead made payable in the name of the IRA custodian and the funds are directly deposited into the Roth IRA.
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.
The 10% Early Distribution Pentaly QUESTION:
The 10% early distribution applies to solo 401k distributions where the participant is under age 59 1/2 at time of the distribution. The conversion of voluntary after-tax contributions to a Roth IRA or a Roth Solo 401k is not subject to the 10% early distribution penalty because the movement of the funds from the solo 401k to the Roth IRA or the Roth Solo 401k is considered a conversion not a distribution.
Reporting to IRS QUESTION:
Please CLICK HERE to learn how after-tax solo 401k contributions are reported.
Still Time to Contribute QUESTION:
You can still make the full after-tax contribution because you have until the annual solo 401k contribution deadline of March 15, 2019 or September 15, 2019 if your file a timely business tax return extension to make all contributions types (i.e., employee, and profit sharing).
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:
If the after-tax contributions are separately accounted for, the pro-rata rule only applies to the solo 401k after-tax sub-account (and if there are no gains on the after-tax contributions the pro-rata rule effectively does not apply).
- 72(d)(2) allows for separate accounting
- Per IRS Notice 2014-54 the pro-rata rule applies at the account level