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How a Client's Solo 401(k) Can Become a Mega Backdoor Roth IRA

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What You Need to Know

  • Solo 401(k)s for side jobs or businesses can possibly be rolled into mega backdoor Roth IRAs.
  • Only after-tax contributions are allowed to be used in this strategy.
  • A client's successful side business must not be related to regular job to take advantage of this rollover.

Solo 401(k)s — in addition to company 401(k)s — can help clients save additional retirement money on an after-tax basis, even with the possibility of converting them to mega backdoor Roth IRAs, but there are rules, according to Ian Berger, an IRA analyst with Ed Slott & Co.

Why Solo 401(k)s?

A solo 401(k) is a retirement account for a sole proprietor and their spouse. The account is particularly advantageous if it’s tied to a side company unrelated to the client’s main company or business.

Let’s say your client normally works as a corporate manager at a food company but at night he has a side business as an artist for comic books. This side job is profitable, and is not considered a “related entity” to his main job by the Internal Revenue Service.

This would be an opportunity to set up a solo 401(k) that would allow him to put in up to $58,000 in after-tax contributions — assuming the side business was profitable.

Berger notes that a client couldn’t contribute more than what they earn in the side job to that solo 401(k). “So this isn’t going to be for everyone,” he says.

A second part of this is being able to convert those after-tax contributions to a mega backdoor Roth IRA, an option that is “virtually tax-free,” he notes in his blog.

Solo 401(k)s, like company 401(k)s, have required minimum distributions beginning at age 72, while Roth IRAs do not.

The Mega Backdoor Roth IRA Conversion

To do this, a solo 401(k) must allow after-tax contributions and in-service (while the person is still working) distributions of after-tax contributions, and the client would need to be able to afford to contribute the after-tax contributions, Berger notes.

The money in the solo 401(k) that fits those specifications then can be rolled into a Roth IRA.

The example Berger provides is someone with a 401(k) with her company and a separate sole proprietorship that is not related to her company.

Her side company is very profitable one year, so she is able to contribute $58,000 to the solo plan. To take advantage of the mega backdoor Roth, she takes a distribution of her solo plan after-tax account and converts that to a Roth IRA. Again, Berger says, a mega backdoor Roth must be done with after-tax contributions.

One point Berger makes about solo 401(k) plans is “they’re not subject to a lot of rules that govern regular 401(k) plans. They’re not subject to ERISA and … they aren’t subject to IRS rules that apply to 401(k) plans like non-discrimination rules.”

Caveats

However, he cautions, this strategy isn’t for those who don’t have a successful side business or aren’t doing well financially.

“The last thing you want to do is to take your earnings from that side job and put them into a retirement account that you’re not going to be able to reach for 20, 30 years down the road,” Berger says. “But for somebody who’s comfortable enough to be able to afford to do that, then this is where the strategy makes sense.”

Again, to get the most out of a solo 401(k), the person’s company and side job cannot be related in the eyes of the IRS, he says.

“In most cases, it’s not a problem,“ Berger says, “but that’s an important point because otherwise, if they’re considered to be [related entities], then you don’t get that separate $58,000 for the solo 401(k), which makes it hard, probably impossible, to use the the mega backdoor.”