If you own your own business and you do not have full-time employees, you can open your own Solo 401(k) plan for your retirement. Many business owners already know this is an option, but they may not know that they can make after-tax contributions to a Roth Solo 401(k), in which distributions are tax-free once you've had the 401(k) for five years and you start taking distributions after age 59 1/2.
For many business owners, the tax deduction is more important than the future tax-free distributions, but there are reasons why you might consider the after tax contribution and future tax-free distributions.
One reason you might consider a Solo Roth 401(k) is you think your income will be higher in retirement than it is now.
Contribution limits in a one-participant 401(k) plan
The business owner wears two hats in a 401(k) plan: employee and employer. Contributions can be made to the plan in both capacities. The owner can contribute both:
Elective deferrals up to 100% of compensation (“earned income” in the case of a self-employed individual) up to the annual contribution limit:
$19,500 in 2020, or $26,000 in 2020 if age 50 or over ($19,000 in 2019, or $25,000 in 2019 if age 50 or over); plus
Employer nonelective contributions up to:
25% of compensation as defined by the plan, or
for self-employed individuals, see discussion below
Total contributions to a participant’s account, not counting catch-up contributions for those age 50 and over, cannot exceed $57,000 (for 2020; $56,000 for 2019).
Another reason is that you may already have an old traditional 401(k) or traditional IRA or a pension. All of these accounts will be taxed as current income when you start taking distributions. On top of that, you will be forced to take mandatory RMD (Required Minimum Distributions) from your tax-deferred retirement accounts. So if this business you own now is a second career, you can create a layered approach to your retirement income, since you never have to take required minimum distributions from a Roth IRA or Solo Roth 401(k). So if you exhaust all the funds in your tax-deferred accounts, you can then start to utilize your Roth accounts to fund your retirement. And if you do use this layered approach, you will have more years to let the Roth accounts accumulate.
One more reason to consider a Solo Roth 401(k) is that perhaps money is a little tight, but you know you need to fund your retirement and you child's college. You may not have thought about this, but you could just fund your Solo Roth (401(k) and fund your child's education from that account as well. But there are some caveats. This strategy would work best if you reach age 59 1/2 before your child goes to college and you've had this account open for more than five years. If this would be the case for you, you could take tax-free distributions and use the money for any purpose you see fit. However, if your child will be starting school before you turn 59 1/2 and after you've had the account open at least five years, you could take a loan of up to $50,000 from your Solo Roth 401(k) to use for your child's education or any other need for that matter. One detail to be aware of is that you must pay back the loan within five years or any remaining balance would be considered a distribution. So if you are under 59 1/2 at that time, you would not only have to pay the tax on the distribution, but you would also pay a 10% penalty for early withdrawal.
The Solo Roth 401(k) is really a great account type to use to fund your child's education if the timing is right for you, because the money would not have to be put towards qualified education expenses like traditional college savings accounts. This flexibility means that whatever expenses come up, it doesn't matter whether they meet any qualified criteria.
Lastly, if you're not too sure your child will actually go to college, then you will not face any tax consequences later on funds in a college savings account that are not used for education expenses.
If you need advice on how to plan for retirement or your child's education, start by having a consultation with a financial planner.