Solo 401(ok) plans are a well-liked retirement financial savings car for self-employed enterprise homeowners. One in every of their key options is the flexibility to make a contribution each as an “worker” of the enterprise and because the “employer”, i.e., the enterprise itself. By maximizing each the worker employer contributions, solo 401(ok) plan homeowners can typically save considerably greater than is feasible with different sorts of retirement plans obtainable to self-employed staff, like SEPs and customary IRAs.
The tax therapy for solo 401(ok) plan contributions can vary from conventional (pre-tax) to Roth to after-tax (i.e., a nondeductible contribution that may be transformed to Roth tax-free). With the caveat, nonetheless, that the sorts of tax therapy obtainable rely upon whether or not the funds are coming from the “worker” or “employer” a part of the contribution. Worker contributions may be made on a pre-tax, Roth, or after-tax foundation, or a mix of all three. However traditionally, contributions from the employer aspect may solely be made on a pre-tax foundation.
In 2022, the SECURE 2.0 Act included a provision that modified the principles for 401(ok) plans (together with solo 401(ok)s) that for the primary time allowed employer contributions to be made on a Roth foundation. Though the rule technically took impact instantly after SECURE 2.0’s passage, it took till late 2023 to concern steering on how Roth employer contributions ought to be reported for tax functions.
Based on the IRS’s steering, Roth employer contributions to a 401(ok) plan are successfully required to be reported as if the contribution had been made on a pre-tax foundation, after which instantly transformed to Roth. Which is sensible in that it would not require wholesale modifications to current tax kinds or payroll methods, however does have an unintended aspect impact for self-employed homeowners of solo 401(ok) and SEP plans who’re additionally eligible for the Sec. 199A deduction for Certified Enterprise Revenue (QBI): As a result of the enterprise’s QBI is lowered by the quantity of any deductible retirement plan contribution, the truth that Roth employer contributions are reported initially as deductible contributions imply that they cut back the enterprise proprietor’s Sec. 199A deduction, though they do not truly cut back their taxable revenue (because the revenue from the Roth contribution is added again within the type of the “phantom” Roth conversion as required by the IRS’s steering).
Accordingly, enterprise homeowners who contribute to a solo 401(ok) or SEP plan and are additionally eligible for the Sec. 199A deduction could need to keep away from making Roth employer contributions, even when their plan supplier permits it. Thankfully, nonetheless, there may be one other solution to maximize Roth contributions to a solo 401(ok) plan that does not have an effect on QBI in any means: If the plan permits worker contributions to be made on an after-tax foundation, the enterprise proprietor can merely make after-tax contributions (all the way in which as much as the $69,000 whole contribution restrict) and convert them to Roth, which is a tax-free transaction because the contributions weren’t deductible to start with. And since there isn’t any deduction for the contribution, it will not have an effect on the QBI calculation in any means.
The important thing level is that, as enterprise homeowners determine on their solo 401(ok) contributions for the yr, they could be unaware of the consequences that making Roth employer contributions might need on their Sec. 199A deductions. For advisors, then, ensuring that enterprise homeowners shoppers are conscious of those results, and giving steering on learn how to work round them by way of after-tax worker contributions, can make sure that they get the utmost profit from their Roth solo 401(ok) financial savings!
