By Dan Federman, CFP®
In a previous blog, we reviewed mega backdoor Roth conversions for “rank and file” employees participating in employer-sponsored 401(k) plans. Today, we’ll take a look at how self-employed business owners can also use conversions to help maximize their retirement savings.
The term “mega backdoor” Roth conversion generally refers to employees’ eligibility to contribute after-tax contributions to their employer-sponsored 401(k) plan and then convert, tax-free, to a Roth 401(k) account.
These after-tax contributions are above and beyond the employee salary deferral limits ($19,000 in 2019, plus $6000 catch-up for those over 50), up to the IRS total contribution limits ($56,000 in 2019, $62,000 for those over 50).
What If You Are a Self-Employed Business Owner?
As a self-employed business owner, you may be wondering if you, too, can “supercharge” your tax-free account balances with mega backdoor Roth conversions.
The answer is yes—by setting up a customized Individual 401(k) plan.
As a self-employed business owner, you can set up a basic Individual 401(k) plan at any discount broker (such as TD Ameritrade, Fidelity, or Schwab) for virtually no cost. These plans typically allow you to contribute pre-tax and Roth 401(k) employee deferrals and pre-tax employer (profit-sharing) contributions.
There are no requirements to file a Form 5500 with the Department of Labor until the plan has assets exceeding $250,000. In many cases, these basic Individual 401(k) plans may be enough to satisfy your needs to maximize your retirement savings.
However, if the combination of your employee and employer contributions falls below the IRS total contribution limits, and your cash flow allows you to save additional dollars into the plan, you may have an opportunity to sock away extra money as after-tax contributions and convert tax-free to a Roth 401(k).
To do this, you’ll need to work with a plan administrator to set up a customized Individual 401(k) plan that includes after-tax contributions and Roth conversions. The cost to set up and maintain one of these plans is around $500 per year. If assets exceed $250,000, you may have an additional fee for filing the Form 5500 each year.
Let’s look at some examples.
Sole Proprietor/LLC Schedule C Income
Janet, a 50-year-old sole proprietor IT consultant, generates $100,000 in net business profits reported on Schedule C of her tax return. She pays self-employment tax of $15,300.
Janet funds her Individual 401(k) with $25,000 in pre-tax elective deferrals and contributes $18,470 as a profit-sharing contribution. Since her plan allows her to contribute after-tax contributions, she contributes an additional $18,530 and elects to immediately convert to her Roth 401(k).
In total, Janet has saved $62,000 for retirement, of which $18,530 can grow tax-free.
Sole Proprietor/LLC Schedule C Income with “Qualified Business Income”
Let’s assume Janet’s business qualifies for the special 20% qualified business income deduction. Janet decides to forego the tax deduction of the pre-tax deferral and profit share contribution because each pre-tax dollar contributed to her retirement plan reduces the 20% QBI deduction. Instead, she contributes her deferral portion to the Roth 401(k) and the remainder into after-tax contributions to be converted to Roth.
It is important to note that the decision to give up the 20% QBI deduction—by making pre-tax contributions into the Individual 401(k) plan—requires careful consideration, especially when the marginal tax rate is under 22% Federal.
Paul, a 52-year-old self-employed media consultant, has elected to file his taxes as an S-corporation. He has chosen to pay himself a W-2 wage of $50,000 and an annual distribution of $50,000.
Through his payroll company, Paul has arranged to defer $25,000 in salary deferrals and 25% of his W-2 income, or $12,500, as a profit-sharing contribution into his Individual 401(k). This results in $37,500 in pre-tax contributions.
Because Paul’s Individual 401(k) plan allows after-tax contributions, he can also make $24,500 in additional after-tax contributions, which he immediately converts tax-free to the Roth account.
In both examples, the self-employed business owners could contribute the maximum $62,000 to their respective Individual 401(k) plans. While Janet enjoyed a larger tax deduction, Paul was able to put more into the Roth account.
While neither option is “right,” they illustrate why it’s important to discuss your goals with your financial planner and coordinate with your CPA. Doing so can help you set up and implement a plan that meets your retirement savings and tax savings goals.
Is There Anything Else I Should Know About Funding My Individual 401(k)?
Your self-employment income will determine your ability to contribute the maximum ($56,000 for those under 50; $62,000 for those over 50).
Sole proprietors reporting Schedule C income can make their contributions up until the personal tax-filing deadline (April 15, or October 15 if an extension was filed).
S-corporations must make employee salary deferrals by the end of the calendar year and need to work with a payroll company. Using a W-2 form, S-corp employees can make a deferral contribution at any time within the year when the income to be contributed is earned.
The timing of the contribution typically depends on the corporation’s payroll structure. Employer contributions must be made by the corporate tax deadline.
Disclaimer: This is not intended to be tax advice. Always consult your CPA before taking any action that has tax implications.
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