Solo Roth 401(k)s Avoid IRA Limits and 401(k) Burdens

Solo Roth 401(k)s Avoid IRA Limits and 401(k) Burdens

Solo Roth 401(k) plans offer more generous contributions limits than Roth IRAs. They also avoid the complexity of non-solo 401(k) plans. They can be adopted for 2020 as late as the filing date (including extensions) for the business owner’s Form 1040 return. 

Post-Year End Adoption and Contributions

A business must adopt a qualified retirement plan by the end of its tax year for a contribution to be deductible for that tax year. Qualified plans include qualified cash or deferral plans (otherwise known as 401(k) plans).

The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 made it possible to adopt and contribute to a qualified plan after the close of the year. Under the change, a business that adopts a qualified plan after the close of a tax year but before the due date for filing its return for the tax year (including extensions) may treat the plan as having been adopted as of the last day of the tax year. This rule is effective beginning for plans adopted in 2021 for 2020.

Comment: Sole proprietors have until the due date of their Form 1040. The normal April 15 due date is automatically extended to May 17, 2021, for 2020 returns because of COVID-19. Form 1040 filers can also file for the normal extension until October 15, 2021 by filing Form 4868.

Roth IRAs of Limited Value to Those Who Would Benefit the Most

Although Roth contributions are not deducted from gross income when made, they are a very good deal for those who can afford to pay the tax up front. Distributions, including growth, are entirely tax free. They are not subject to required minimum distribution rules until the owner dies.

The problem with Roth IRAs is that contributions are limited in two ways. First, the maximum IRA contribution is the greater of compensation or $6,000 (as inflation adjusted for 2021), with a $1,000 catch up for those 50 or older.

Second, and perhaps more important for those most likely to be able to afford the current tax, the ability to make contribution is phased out at income rises. The phase out occurs for couples filing jointly with a modified adjusted gross income (AGI) between $198,000 and $208,000) as adjusted for inflation for 2021. These amounts are $125,000 and $140,000 for single filers.

“Modified” AGI adds back the following deductions and exclusions:

401(k) Contribution Limits

Roth 401(k)s are not subject to the Roth IRA income phaseout. Plus, their maximum contribution far exceeds the annual IRA limit of $6,000.

Roth 401(k)s, like 401(k) plans generally, have a maximum contribution of the greater of compensation or $19,500. Any 401(k) plan can add employer contributions of up to 25 percent of wages or 20 percent of earned income up to a total of $58,000. Catch up contributions of up to $6,500 for those 50 or over can be added on top of the $58,000 cap.

401(k) Nondiscrimination Rules

All well and good, but 401(k) plans can be expensive to administer. Contributions must meet a special actual deferral percentage (ADP) test. That test limits the extent to which elective contributions of highly compensated employees (for 2021, anyone making over $130,000) may exceed elective contributions of rank and file employees. Normally, plans tend to favor highly paid employees because these are the employees who do not live paycheck to paycheck and can afford salary deferrals.

Administering this test or qualifying for one of the contribution safe harbors requires a fair amount of trouble and expertise on the part of the employer. Many employers hire third party administrators. Added burdens include making annual Form 5500 series filings to the Department of Labor, issuing participant statements, and information notices.

Solo 401(k)s Are Easy to Administer

Solo 401(k)s are one participant plans. A business owner with no common-law employees does not need to perform nondiscrimination testing for the plan, since there are no employees to discriminate against. That means no ADP test or worries about safe harbor requirements. In addition, one participant plans use Form 5500-EZ with the IRS, and only if assets are above $250,000.

Compliance Tip: Small business contributions for employees are deducted on Schedule C, and contributions for the taxpayer are deducted on Schedule 1. That means for solo plans that by definition do not include employees, all contributions are deducted on Schedule 1. Note, however, that any portion of the contribution that represents Roth contributions are not deducted and are fully taxed. IRS Publication 560, provides worksheets and rules for self-employed retirement contributions.

Conclusion

Roth Solo 401(k)s are Roth plans that bypass the Roth IRA income limits, and 401(k) plans that avoid the 401(k) nondiscrimination rules. Thanks to the SECURE Act, small business owners may adopt and make contributions to a Roth Solo 401(k) for 2020 as late as the due date of their 2020 Form 1040.

By James Solheim, J.D.