Roth Solo 401(k) Plans: What You Need to Know

Are you a freelancer, a self-employed individual, or a small business owner with no employees? If so, a Roth Solo 401(k) plan might be for you. This type of retirement savings plan marries the high contribution limits of a 401(k) with the tax advantages of a Roth IRA.

There are numerous retirement plans available to investors today. You’ve probably heard of traditional and Roth IRAs, SEP and SIMPLE IRAs, 401(k)s, and more.

However, one often overlooked option is the Roth Solo 401(k), a retirement plan offering unique benefits for the self-employed. This plan provides high contribution limits, diverse investment options, and all the tax advantages of a Roth account.

Many Americans get their retirement savings plan through an employer-sponsored account. But regardless of your career or business path, retirement planning is critical to ensuring a secure financial future.

In this article, we’ll explore everything you need to know about Roth Solo 401(k)s, including eligibility requirements, investment options, rules, and regulations.

Eligibility and Contributions

Understanding the Roth Solo 401(k) means knowing who is eligible, the contribution limits, and the rules surrounding those contributions. Let’s get into the details.

Eligibility criteria

The first thing to note is that not everyone qualifies for a Roth Solo 401(k). It’s an account specifically designed for self-employed individuals, freelancers, or small business owners with no employees other than a spouse. For example, if you’re a freelance writer, a solo lawyer, or an owner of a home-based online business with no employees, then you qualify.

The beauty of a Roth Solo 401(k) plan lies in its flexibility and its high contribution limits, allowing you to contribute both as an employee and employer. However, you must have an earned income from your business to contribute. So, if your business doesn’t profit in a particular year, your Roth contributions will be limited.

Maximum contribution limits

One of the primary advantages of a Roth Solo 401(k) is its high annual contribution limits, making it an attractive retirement savings option for those with substantial self-employment income.

As of 2023, you can contribute up to $22,500 annually in after-tax dollars as an employee, or up to 100% of your compensation, whichever is less.

But here’s the kicker: you can also make employer profit-sharing contributions of up to 25% of your compensation, up to $66,000 per year (after subtracting your employee contributions). As we’ll discuss, people 50 and over can make additional catch-up contributions as part of the employee contribution piece.

These higher-than-usual limits can dramatically increase your savings and allow for significant tax-free growth.

Catch-up contributions for those 50 and older

If you’re 50 or older by the end of the tax year, you can make catch-up contributions. This means you can contribute an extra $7,500 as part of your employee contribution on top of the regular $22,500 limit.

This feature enables older savers to accelerate their savings as they approach retirement age.

Employer contributions

Employer contributions refer to the non-deductible contributions that you, as the business owner, make to your Roth Solo 401(k) plan. These contributions are based on a percentage of your self-employment income, up to 25%.

The combined total of employee and employer contributions can’t exceed $66,000 in 2023 (plus $7,500 if you’re over 50 and making catch-up contributions).

For example, if your self-employment income is $100,000, you could make a maximum employee contribution of $22,500 and a maximum employer contribution of $25,000 (25% of $100,000).

These contributions, known as profit-sharing contributions, provide a fantastic opportunity to increase your retirement savings when you don’t have access to benefits like employer matching through a traditional 401(k).

Remember, however, that contribution limits affect the amount you can put in as the employer. Therefore, it’s crucial to calculate your net self-employment income accurately to determine your maximum possible contribution. Additionally, you should be aware that total contributions cannot exceed your income in a given year.

While there is no obligation to make employer contributions, doing so can dramatically boost your savings. Additionally, the flexibility in adjusting employer contributions from year to year can be advantageous for businesses with variable profitability.

Roth Solo 401(k) Plan Investments

When it comes to investing your Roth Solo 401(k) funds, the options are plentiful. You aren’t limited to the standard fare of stocks, bonds, and mutual funds. Instead, you can invest in various asset classes, depending on your risk tolerance and investment preferences.

Investment options

You can invest in various assets in a Roth Solo 401(k) plan. Traditional options include stocks, bonds, mutual funds, and exchange-traded funds (ETFs). These offer diverse opportunities for growth and income, and you can balance your portfolio according to your investment strategy and risk tolerance.

But the investment options don’t stop there. You also have the opportunity to invest in real estate securities, which can add further diversity to your portfolio. You can even use your Roth Solo 401(k) funds to start or invest in a business (as long as it’s not a business you or a disqualified person owns or controls).

Investment restrictions

Despite the wide range of investment opportunities, there are some restrictions to bear in mind. There are rules around prohibited transactions and disqualified persons, which are intended to prevent self-dealing or conflicts of interest.

Prohibited transactions include borrowing money from the plan, selling property to it, using it as security for a loan, or buying property for personal use (either directly or indirectly) with plan assets. Disqualified persons include the plan owner, their family members, and any businesses they control.

Violating these rules can lead to dire consequences, such as disqualification from the plan and a hefty tax bill. Understanding these restrictions is crucial before you start investing your Roth Solo 401(k) funds.

Importance of diversification

Diversification is critical when investing your Roth Solo 401(k) funds. Having a variety of investments can help protect your retirement savings from the volatility of financial markets. For instance, if you invest all your money in one sector or type of investment and that sector or investment takes a hit, your entire retirement savings could suffer.

Instead, you can reduce your risk by spreading your investments across different asset classes (stocks, bonds, real estate) and sectors (technology, health care, manufacturing). If one investment performs poorly, it’s balanced by others that may be doing well.

Rules and Regulations

Like any other retirement plan, the Roth Solo 401(k) plan is regulated by the Internal Revenue Service and subject to rules. Let’s explore those below.

IRS regulations

While flexible and advantageous, Roth Solo 401(k) plans are subject to numerous regulations imposed by the Internal Revenue Service (IRS). These rules govern every aspect of the plan, from contributions to investments, withdrawals, and taxation.

• Contributions: Employee and employer contributions have annual limits set by the IRS, which are adjusted periodically. It’s essential to be aware of these limits and not exceed them, as over-contributing can lead to tax penalties.
• Distributions or withdrawals: You can withdraw your contributions tax-free and penalty-free anytime. However, to withdraw your earnings tax-free, you must be 59½ years old, and at least five years must have passed since your first contribution to the plan. Otherwise, you might face a 10% early withdrawal penalty.
• RMDs: Unlike Roth IRAs, Roth Solo 401(k) plans are subject to Required Minimum Distributions (RMDs) when the owner reaches 73. However, if you still work past that age and don’t own more than 5% of the business that employs you, you may be able to delay RMDs until you retire. Note that as of 2024, Roth Solo 401(k) RMDs will no longer be required.
• Investments: As your own asset manager, you decide how the plan’s assets are invested. As previously mentioned, the IRS restricts prohibited transactions and dealings with disqualified persons.

Plan documents

Maintaining proper documentation is a good business practice and crucial for complying with IRS regulations. Key plan documents include the adoption agreement, which establishes the plan, and the plan document, which details the plan’s operation and administration.

These documents outline the plan’s provisions, including contribution limits, investment options, and distribution rules. They also define the rights and responsibilities of all parties involved: the plan owner, participants, and any administrators or trustees.

It’s essential to keep these documents up to date and in a safe place. They can be vital in case of an IRS audit, disputes over plan terms, or simply for reference.

Filing requirements

As a Roth Solo 401(k) plan owner, you’re also responsible for meeting specific filing requirements. This includes filing an annual Form 5500 with the IRS once your plan’s assets exceed $250,000. This form provides information about the plan’s financial conditions, investments, and operations.

Failing to comply with these requirements can result in penalties and potentially jeopardize the plan’s tax-advantaged status. Therefore, it’s essential to stay organized, keep accurate records, and seek professional advice if needed.

Advantages and Disadvantages

Like any retirement plan, a Roth Solo 401(k) plan has pros and cons. Understanding these can help you decide whether this plan is the right choice for your retirement savings strategy.

Advantages of a Roth Solo 401(k) plan

• Tax advantages: One of the significant advantages of a Roth Solo 401(k) plan is the ability to make after-tax contributions. While you don’t receive a tax deduction for tax-deferred contributions (as you do with a traditional 401(k)) your withdrawals in retirement are tax-free so long as they are deemed qualified distributions. This can be a substantial benefit if you expect to be in a higher tax bracket in retirement.
• Contribution limits: A Roth Solo 401(k) plan also allows for high contribution limits, enabling you to accumulate substantial savings for retirement. The total annual contribution limit for 2023 is $66,000 (plus $7,500 if you’re 50 or older), significantly higher than the $6,500 limit for a Roth IRA.
• Diverse investment options: Another advantage is the flexibility in investment options. Not only can you invest in traditional securities like stocks and bonds, but a Roth Solo 401(k) plan also allows investments in alternative assets like real estate, which can be an attractive feature for those seeking diversification beyond the stock market. Moreover, with a self-directed Roth Solo 401(k) plan, you can have more control over your investment decisions, depending on the plan provider.
• Loans: A Roth Solo 401(k) plan may offer loan provisions. This means you may borrow from your plan under certain circumstances, which can be handy in financial emergencies. However, the borrowed amount must be repaid with interest to avoid tax penalties.

Disadvantages of a Roth Solo 401(k) plan

• Eligibility: One significant limitation is that not everyone is eligible for this type of plan. It’s specifically designed for self-employed individuals and small business owners with no full-time employees other than a spouse.
• No immediate tax deferrals: Unlike traditional 401(k) plans or traditional IRAs, contributions to a Roth Solo 401(k) don’t offer an immediate tax benefit. Since contributions are made with after-tax dollars, they don’t reduce your current taxable income. Therefore, a traditional Solo 401(k), SEP-IRA, or traditional IRA might be a better choice if you’re seeking an immediate tax deduction.
• RMDs: Another potential downside is the Required Minimum Distributions (RMDs). Unlike Roth IRAs, Roth Solo 401(k) plans must start taking RMDs at age 73, though this requirement will end in 2024 due to recent legislation.
• Complexity: Finally, administrating a Roth Solo 401(k) plan can be more complex than managing an IRA due to the plan’s compliance requirements, paperwork, and potential tax reporting.

Comparison to Other Retirement Savings Options

Now that we’ve outlined the advantages and disadvantages of a Roth Solo 401(k) plan let’s compare it with other popular retirement savings options.

Roth Solo 401(k) vs traditional 401(k) plans

Roth Solo 401(k) and traditional 401(k) plans share several similarities but have crucial differences. Both types of plans offer high contribution limits, the ability to make catch-up contributions for those over 50, and the option for plan loans.

However, the critical difference lies in the tax treatment of contributions and withdrawals. With a traditional 401(k), contributions are made with pre-tax dollars, reducing your taxable income in the year you contribute. This could benefit you if you’re currently in a high tax bracket. However, withdrawals in retirement will be taxed as ordinary income.

In contrast, Roth Solo 401(k) contributions are made with after-tax dollars, with no immediate tax deduction. However, the benefit comes in retirement when withdrawals are tax-free, as long as they are qualified distributions.

Roth solo 401(k) vs IRAs

Individual Retirement Accounts (IRAs) are another standard retirement savings vehicle. Like Roth Solo 401(k) plans, Roth IRAs allow after-tax contributions and offer tax-free withdrawals in retirement.

However, the primary difference is the contribution limit. For 2023, the contribution limit for a Roth IRA is $6,500 ($7,500 if you’re age 50 or older), significantly lower than that of the Roth Solo 401(k) plan.

Furthermore, Roth IRAs have income restrictions. If your income is above a certain threshold, you may not be eligible to contribute to a Roth IRA. In contrast, Roth Solo 401(k) plans do not have the same income limits for eligibility.

Roth solo 401(k) vs SEP-IRAs and SIMPLE IRAs

Simplified Employee Pension (SEP) IRAs and Savings Incentive Match Plans for Employees (SIMPLE) IRAs are other options for self-employed individuals and small businesses.

SEP IRAs allow employers to contribute to their employees’ IRAs. The contribution limits for SEP IRAs can be higher than traditional or Roth IRAs but less than a Roth Solo 401(k).

On the other hand, SIMPLE IRAs, like SEP-IRAs, allow contributions from both the employer and the employee. They also have higher contribution limits than traditional or Roth IRAs but can be less than those allowed to a Roth Solo 401(k).

The tax treatment of contributions and withdrawals in SEP and SIMPLE IRAs is similar to a traditional IRA or traditional 401(k), where contributions are pre-tax, and withdrawals are taxed at ordinary income tax rates.

How to Set Up a Roth Solo 401(k) Plan

If you’ve decided that a Roth Solo 401(k) plan is the right fit for your retirement savings strategy, here’s how you can set one up:

1. Choosing a provider: Start by researching different providers that offer Roth Solo 401(k) plans. Consider the fees they charge, the investment options they provide, their brokerage interface, their customer service reputation, and their platform’s user interface.
2. Get an Employer Identification Number: If you don’t already have one, you’ll need an EIN to set up a one-participant plan.
3. Setting up the plan: Once you’ve chosen a provider, you’ll need to complete some paperwork to set up the plan. This usually includes an adoption agreement and plan documents that lay out the details of your plan. Complete everything accurately and honestly, as providing incorrect information could lead to penalties.
4. Administering the plan: After your solo 401(k) plan is set up, you’ll need to manage it by making contributions, selecting investments, and monitoring performance. Ensure you keep accurate records of all transactions related to your Roth Solo 401(k) and stay compliant with IRS regulations.

Remember, if your income comes from self-employment, you’ll likely need to pay self-employment tax, which can affect your net earnings and, consequently, your contributions to the Roth Solo 401(k) plan.

Get help from a tax professional when managing your income, earnings, and contributions for the tax year.

Need Help Moving Your Roth Solo 401(k) Plan?

A Roth Solo 401(k) plan can be an excellent tool for self-employed individuals and small business owners to save for retirement. It offers high contribution limits, tax-free withdrawals in retirement, and the flexibility to invest in a wide range of assets.

However, finding and consolidating old Roth Solo 401(k) plans can be complex, and getting it right is crucial for your financial future. That’s where Capitalize comes in. We can help you navigate the process, from helping you compare IRA accounts to managing the entire rollover for you.

Contact us today to start your journey to a more secure and comfortable retirement.