Solo 401(ok) plans are a well-liked retirement financial savings automobile for self-employed enterprise house owners. One in every of their key options is the power to contribute 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 house owners can usually save considerably greater than is feasible with different forms of retirement plans accessible to self-employed employees, like SEPs and normal 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 forms of tax therapy accessible depend upon whether or not the funds are coming from the «worker» or «employer» a part of the contribution. Worker contributions could be made on a pre-tax, Roth, or after-tax foundation, or a mixture 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 foundations 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 situation steerage on how Roth employer contributions ought to be reported for tax functions.
In keeping with the IRS’s steerage, 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 smart in that it would not require wholesale adjustments to current tax types or payroll programs, however does have an unintended aspect impact for self-employed house owners 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 decreased 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, although they do not truly cut back their taxable revenue (for the reason that revenue from the Roth contribution is added again within the type of the «phantom» Roth conversion as required by the IRS’s steerage).
Accordingly, enterprise house owners who contribute to a solo 401(ok) or SEP plan and are additionally eligible for the Sec. 199A deduction might need to keep away from making Roth employer contributions, even when their plan supplier permits it. Happily, nonetheless, there may be one other technique to maximize Roth contributions to a solo 401(ok) plan that does not have an effect on QBI in any manner: 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 best way as much as the $69,000 whole contribution restrict) and convert them to Roth, which is a tax-free transaction for the reason that contributions weren’t deductible to start with. And since there is no deduction for the contribution, it will not have an effect on the QBI calculation in any manner.
The important thing level is that, as enterprise house owners determine on their solo 401(ok) contributions for the 12 months, they might be unaware of the consequences that making Roth employer contributions may need on their Sec. 199A deductions. For advisors, then, ensuring that enterprise house owners purchasers are conscious of those results, and giving steerage on how you can work round them by way of after-tax worker contributions, can be certain that they get the utmost profit from their Roth solo 401(ok) financial savings!