The John C. Bogle Center for Financial Literacy is pleased to sponsor the 27th episode of Bogleheads® Live. In this episode Sean Mullaney, a financial planner and author of his new book, "Solo 401(k): The Solopreneur's Retirement Account."
Sean returns to Bogleheads Live to answer your questions about the solo 401(k).
Sean Mullaney
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Transcript
Jon Luskin: Bogleheads® Live is our ongoing Twitter Space series where the do-it-yourself investor community asks their questions to financial experts live on Twitter. You can ask your questions by joining us for the next Twitter Space. Get the dates and times of the next Bogleheads® Live by following the John C. Bogle Center for Financial Literacy on Twitter. That’s @bogleheads.
For those that can’t make the live events, episodes are recorded and turned into a podcast. This is that podcast.
Thank you for joining us for the 27th Bogleheads® Live. My name is Jon Luskin, and I’m your host. Our guest for today is Sean Mullaney.
Let’s start by talking about the Bogleheads®, a community of investors who believe in keeping it simple, following a small number of tried-and-true investing principles.
This episode of Bogleheads® Live, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, a 501(c)(3) nonprofit organization dedicated to helping people make better financial decisions. Visit our newly redesigned website at boglecenter.net to find valuable information and to make a tax-deductible donation.
Mark your calendars for future episodes of Bogleheads® Live. Next week, we’ll have Meg Bartelt answering your questions about equity compensation. If you’ve got questions about RSUs, ISOs, NQSOs, and more, check that out.
[00:01:19] Before we get started on today’s show, a disclaimer. This is for informational and entertainment purposes only. It should not be relied upon as a basis for investment, tax, or other financial planning decisions.
Let’s get started on today’s show with Sean Mullaney. Sean Mullaney is a fee-only, advice-only financial planner and Certified Public Accountant (CPA). He blogs on tax and financial independence at fitaxguy.com, and you can follow him on Twitter @SeanMoneyandTax and his new YouTube channel.
Sean was also a guest on the 11th episode of Bogleheads® Live, where he and fellow early retirement expert Cody Garrett fielded audience questions about tax planning for early retirement. I’ll link to that episode in the show notes for our podcast listeners.
Sean recently released his book on the ‘Solo(k)’ - the Individual 401(k) - entitled “Solo 401(k): The Solopreneur’s Retirement Account”. And that’s going to be our topic today: the Solo 401(k).
A 401(k) is a tax-advantaged investment account for retirement. Folks have access to this through their employers frequently, or maybe they have access to a similar version of 403(b) or 457. Yet, if you are self-employed, you’re not necessarily going to have that. You can create your own tax-advantaged account for retirement, the Solo 401(k).
Sean Mullaney, thank you for joining us on Bogleheads® Live. Let’s start with a little bit of an intro, a little bit of a basic question. This question is from user ‘Nahtanoj’ of the Bogleheads® forum, who writes:
“Is the Solo 401(k) available to people who work as independent contractors rather than employees? And who might receive a 1099 at the end of the year rather than a W-2?”
Sean Mullaney: Yeah, that’s a great question. And Jon, thank you so much to you and to all the Bogleheads® for having me here today. Looking forward to diving in.
Let’s think about who a solopreneur is. It’s generally someone who works for themselves. They’re going to get payments in all different sorts of forms, and when they do their tax return for the year, the self-employment income is reflected on what’s called a Schedule C. And that’s generally going to form the basis for what could potentially be contributed to a Solo 401(k).
It turns out that there are many solopreneurs who will have a business where they’re going to receive from their clients and customers 1099 forms reporting that income. There are also going to be plenty of solopreneurs who have clients who are not required to issue them a form 1099. So, it’s very important to keep good books and records so that you can prove your income and support your Solo 401(k) contributions.
There’s a lot entangled there when we have both a W-2 job and a side hustle. Very navigable, talk about it a lot in the book, but there’s things you want to keep in mind.
Let’s say you have a solopreneur / side hustler. They earn $10,000 in the side hustle, and separately they have a W-2 job. They earn $50,000 or $60,000. And, for whatever reason, there’s no retirement plan at the W-2 job.
What are the Solo 401(k) contribution limits in that case? And in that case, it’s generally going to be based on the $10,000 of self-employment income only. So, what that means is other W-2 income does not create runway or limitation to be able to fund your Solo 401(k). If you’re funding your Solo 401(k), you only can look to the income generated by the self-employment activity. And then you do have to coordinate Solo 401(k) and 401(k) contributions at work, if you have a 401(k) at work.
Folks may be familiar with the $20,500 limitation for 401(k) employee contributions, commonly referred to as employee deferrals. That’s spread out over all 401(k) plans. So, if you’re a side hustler and you max out the 401(k) at work for $20,500, you’re under age 50, well that’s okay. There’s nothing necessarily wrong with. But, it means in terms of employee contributions to a side hustle Solo 401(k), you’d be at zero. You still could do employer contributions. Still might be the right path for you.
Jon Luskin: This question is from the Bogleheads® forums and the user writes:
“Apparently, people who made after-tax contributions to a traditional IRA that also holds pre-tax contributions and/or investment proceeds can roll over the pre-tax money of the IRA into a traditional 401(k) or into a Solo 401(k), and then withdraw the after-tax contributions from the IRA - the basis - or roll them into a Roth IRA without paying tax on them. Reportedly, this results in more favorable tax treatment of withdrawals from the traditional IRA than would otherwise apply under the pro-rata rule, sometimes called the ‘cream in the coffee’ rule.
Does Sean have any practical experience with executing this kind of maneuver? And can he offer any tips on how it can be executed without the account holder getting himself into trouble?”
Sean Mullaney: This is asking about this issue of having basis in a traditional IRA. We tend to see this with older clients. A lot of younger clients these days understand the backdoor Roth IRA, and so when they create basis in a traditional IRA by doing a non-deductible contribution, relatively quickly in time, they’re converting to a Roth. And, so they don’t have lasting basis in a traditional IRA.
But if we look at some older clients, people who were doing non-deductible traditional IRA contributions before the backdoor Roth IRA contribution became in vogue in 2010, 2011, they may have some old basis in traditional IRAs. And so, there’s some planning where we could hive off that basis.
Take one example. You have $100,000 in a traditional IRA, and you made previous non-deductible contributions to that IRA of $12,000. It’s $12,000 basis, $100,000 total fair market value. So, folks say, “oh boy, if I do Roth conversions out of that, or if I take withdrawals from that most of that’s going to be taxed and I recover some basis, but the value of the basis is getting eroded away by inflation. So maybe I could hive off the basis and get the basis alone into a Roth.”
So here’s what folks do. They say, “Oh, I have a 401(k) plan at work. What I’m going to do is I’m going to roll the growth, the pre-tax piece, so the $88,000 in my example, into the 401(k).” And here they’re taking advantage of a tax rule that’s actually taxpayer favorable. The tax rule says the following, it says, ‘basis in a traditional IRA cannot be rolled into a plan.’ So, in my example, $12,000 basis, $100,000 total value, the most a person can get into the 401(k) at work is $88,000. The $12,000 basis has to stay behind.
So this gets a little tricky and there’s what I like to refer to as execution risk. From a practical perspective, and this is not investment advice for anyone, what someone might want to do is they might want to, in this situation, they like their 401(k) at work. We’re going to take our basis amount - we have a lot of confidence in that basis amount - hopefully, it’s proved out by form 8606s. You could look back at old 5498s, maybe old brokerage statements. Okay, I’m convinced of my basis.
I’m going to get that basis amount into, say, a money market fund where I’m pretty sure there’s no risk of it going down in value. I’m going to set that to the side inside my traditional IRA. The rest of the assets, I do a direct trustee-to-trustee roll-in from IRA to 401(k).
Step one is get my basis (and maybe a little rounding up) into a money market fund inside the traditional IRA. (That’s $12,000 in my case.) Step two, direct trustee-to-trustee transfer from IRA to 401(k) of the growth, of the pre-tax amount. It’s probably more than growth. But pre-tax amount. $88,000 goes from IRA to 401(k) in my example. The rest of the assets - approximately $88,000 – so, now they’re sitting in the 401(k) and they’re not subject to the pro-rata rule. So, that’s pretty cool.
Step three then is, “oh, I left my basis behind in my traditional IRA, and I have no other IRAs.” Let’s stipulate that, too. That’s a very important stipulation: no other traditional IRAs, SEP IRAs and SIMPLE IRAs. So step three is, I convert the $12,000 and any change remaining in the traditional IRA to a Roth IRA.
I’ve now synthetically remanufactured the backdoor Roth IRA using my workplace plan. So that $12,000 goes from traditional IRA to Roth IRA and almost entirely tax-free because of my historic basis in my traditional IRA.
Sean Mullaney: When we think about that in conjunction with a Solo 401(k), the one risk that I see that I think is worth discussing in this forum is Solo 401(k) qualification. Meaning, if you’re thinking, “Hey, you know, I’m a stamp collector and I have about five stamp sales a year,” eh, that may not be a self-employment business. So, that really may not support a Solo 401(k).
[So you just want to be extra careful that you have a real good self-employment business. There’s no question about plan qualification from that perspective. It’s not a good idea to roll into a Solo 401(k) that doesn’t qualify because you don’t really have a self-employment business. That can create a world of hurt.
These things are all very possible, but you’ve really got to look at your particular facts and make sure it’s the right move for you.
Jon Luskin: Effectively, what you’ve done is you’ve gone back in time and you’ve done part two of the backdoor Roth IRA contribution that you forgot to do in the past. So, this is a pretty neat strategy.
Sean, let me move on to part two of this question. The user writes:
“I have several traditional IRAs. I know that I have basis in at least one of my traditional IRAs from past years’ non-deductible contributions because that basis is reflected on form 8606 of my tax return. But I don’t know which traditional IRAs have the basis. Can I make that Roth conversion of the basis without tripping the pro-rata rule?”
Sean Mullaney: This is something folks get tripped up on all the time. They say, “oh, you know, I have two IRAs. One of them is my old 401(k) from all Employer A, and that’s all pre-tax. There’s no basis, nothing there. But then separately, I did a $6,000 non-deductible traditional IRA contribution. So that’s the IRA with basis.” It does not work that way. For the purposes of the pro-rata rule, all of this stuff is melded together into one IRA.
The rules say, for purposes of this pro-rata rule, all distributions from the year are considered one distribution. And all traditional IRAs, SEP IRAs and SIMPLE IRAs are one IRA.
That previous example I gave you: $100,000 in a traditional IRA, $12,000 basis. The results are the absolute same, whether that’s one IRA, two IRAs, three IRAs, or 10 IRAs; it doesn’t matter. You have to look at all your IRAs, and this includes SEP IRAs and SIMPLE IRAs, as one big pile of IRA. What’s the fair market value, and what’s the total basis? If I take a dollar out of any one of those IRAs, it attracts a ratable amount, (a pro-rata amount of the basis that exists), even if that basis didn’t come into creation with respect to that particular account.
The pro-rata rule smooths this stuff altogether. There’s no specific identification. “This IRA has basis and that one doesn’t?” Nope. The tax rules say they’re all one IRA, and the basis is smoothed over any potential distribution, with the exception that I talked about, where you do a plan roll-in.
Let’s say they have six IRAs. Total fair market value is $100,000, and they have $12,000 of proven basis from old non-deductible contributions. Take one of those IRAs, and make it worth $12,000 of money market funds. That’s step one. Then step two would be to take IRAs two through six, do the IRA-to-401(k) direct trustee-to-trustee roll-in, that would be step two. And then step three is: Roth conversion of the $12,000 we left behind. You don’t have to take basis with you when you do a plan roll-in, and in fact, you can’t. This is Roth hiving off basis so that we isolate basis so that we can do tax-efficient Roth conversions that are much like the backdoor Roth conversion.
There’s a lot of confusion on this stuff out there. Just search for ‘8606’ on fitaxguy.com, and you’ll see a bunch of blogs I’ve done about it.
Jon Luskin: Got it. So, to make sure I understand, for this case study: they’ve got two IRAs, $50,000 in each of them. One of them has $12,000 in basis, but they don’t know which one has that basis.
Sean Mullaney: What your mind is going to, is this logical, “Well wait a minute. I created the basis with respect to one of these IRAs. It’s got to attach to one of these IRAs,” and that’s your logical brain working, which is great. But, for this purpose, you got to use what Congress did. And Congress said, these are all one IRA for this purpose.
What the tax rules then do is say, “Well, okay, you may have one IRA, two IRAs, or six IRAs. You have one IRA.” I’m not saying it’s logical, I’m just saying that’s what’s in the Internal Revenue Code. It says “you have one IRA for these purposes.” Okay, well, technically, it’s at two different financial institutions, but okay Congress and IRS, you’re telling me I have one.
Well, all right, now I’m going to play with the rules to my favor. Step one is the money market piece of it. Keep that basis so that we don’t go below the basis number when we move money into the 401(k). So, step one is just to put $12,000 in any one of these IRAs. Make sure we got that basis and round up. And then step two is: everything else goes into the 401(k) at work. (We like that, hopefully.) And then step three is do the Roth conversion.
Jon Luskin: Fantastic. Great. So, it doesn’t matter if X years ago they put their non-deductible contribution into the Schwab IRA and now they’re going to be leaving what they’re going to assume is basis in the Fidelity IRA. For tax purposes, IRS doesn’t care that it’s the same dollar, they just want the dollar amount to be the same.
Sean Mullaney: That’s basically right.
Jon Luskin: Fascinating. That’s super neat. Okay, so cream-in-the-coffee rule doesn’t necessarily, generally, have to be the exact dollar so much as the same amount of dollars.
This one is from username ‘ThankYouJack’ from the Bogleheads® forums, who writes:
“Would Sean ever recommend dealing with complexities to do a mega backdoor Roth in a Solo 401(k)? If so, when does it make the most sense, and what is the simplest approach?”
Sean Mullaney: Keep two things in mind here, and one goes back to what I refer to as execution risk. The mega backdoor Roth IRA - I think a lot of the Bogleheads® folks know this - it’s a 401(k) contribution that’s in addition to regular employee contributions that get money into a Roth IRA or Roth 401(k). It’s a workaround around the $20,500 employee deferral limit into a Roth for the year for a 401(k). Perfectly legal. There’s an IRS notice from 2014 that sort of lays it all out. But here’s the thing: a lot of 401(k) plans don’t offer it. More and more plans are starting to offer it, but a lot don’t.
In the Solo 401(k) realm, you must consider the plan providers. And a lot of the bigger financial institutions offer what the IRS refers to as a pre-approved Solo 401(k) plan. And what that does is lowers the compliance risk. Using a pre-approved plan is what I’m biased towards. It’s what I generally recommend in most cases.
Most pre-approved plans at large financial institutions do not offer after-tax contributions, and thus don’t offer the mega backdoor Roth IRA for the Solo 401(k). From an implementation/execution perspective, it’s more difficult to do. It’s doable. You just have to use a non-preapproved plan in most cases. So, you’re going to have to avoid a lot of the larger, low-cost financial institutions. I say, “oh, mega backdoor Roth for a Solo 401(k), at least if I can’t get into a pre-approved plan, I might want to rethink that.” So that’s the first point.
The second point though, is actual numbers. The mega backdoor Roth IRA tends to make a lot more sense in the context of a large W-2 employer 401(k) plan. It’s just the way the numbers work out with the employer contribution.
Let’s think about an example. You go to a large employer. You’re making $100,000 W-2 salary. What can you get into the 401(k) before the mega backdoor Roth? Let’s assume you’re under 50 years old, so $20,500 employee deferral. And then maybe the employee has an employer match. They say for the first 6%, we’ll put in 50%. To get $3,000 of an employer match under that formula, right? 50% of 6% of $100,000. $3,000. Some quick math. So now you’ve got $22,500 into your 401(k) at work.
Especially for folks maybe in the financial independence community, they may have a lot of money now sitting on the sidelines. They can do that mega backdoor Roth, and they have plenty of limitations. The overall limit is $61,000 for the year in that case. Practically, they may just have a lot of excess cash. Let’s do mega backdoor Roth at work. Makes a ton of sense.
Now, let’s move to a Solo 401(k). Schedule C income is $100,000. You still get that $20,500 that you could do traditional or Roth employee contribution. But now the employer contributions totally change. You’re not limited by your employer’s policies. You’re the employer. You get to make the policy. And you can go, in that case, up to an additional $18,500, roughly speaking, of employer contribution and get a tax reduction for that.
That solopreneur gets $20,500 employee, $18,500 employer. That solopreneur on $100,000 of Schedule C, before they even think about a mega backdoor Roth, is at $39,000 of contributions. That leaves them with $61,000 of cash flow for living expenses, federal and state income taxes, and payroll taxes.
If I’m that solopreneur, and I’ve already got 39% of my pre-tax, my gross income, into a Solo 401(k), I think I’m done at that point. I don’t think the mega backdoor Roth, is all that important in terms of my planning. Cause I may not have the cash flow between paying payroll taxes, income taxes, and personal living expenses. I may need the rest of that $61,000.
My perspective is, based on the numbers and based on losing the availability of many of the pre-approved plans at larger financial institutions, I tend to disfavor, in most cases, the mega backdoor Roth IRA in the Solo 401(k) context. There are plenty of folks who do it and have success with. In many cases, it requires a little more administrative setup, and it requires maybe losing out.
What those people often are doing is, they’re skewing the deductible employer contribution. You have to think about that in the context of, “wait a minute, at the highest earning years of my career potentially, is that the right decision?” This also then boils down to the classic traditional versus Roth debate, in terms of contributions. And your mileage may vary, and people can approach that in different ways.
I tend these days to lean in towards taking the deductions. Fully understand Roth has a lot of value. A lot of my clients have at least some FIRE or FI lens. So, if we can get retired before we take Social Security, we at least have some hope of doing Roth conversions at a low tax bracket.
Jon Luskin: To clarify, if you’ve got a 401(k) or 403(b) or 457 at your workplace, the contribution limit for this year, if you’re under age 50, is $20,500. Then your employer can make some amount of profit-sharing or matching contribution. They can contribute up to $40,500.
Now, if you’re self-employed, if you’re making your own money in your own business, you can get an additional $40,500 into that 401(k), into that ‘Solo(k)’ via profit-sharing or employer contributions. So, if you’re self-employed, if you’re that solopreneur, if you’ve got that side hustle with sufficient profit from your business, you can get up to $61,000 into a Solo 401(k) for the year if you’re under age 50. It can be a pretty powerful saving and investing vehicle for retirement.
Zinkeng can ask his question on Solo 401(k)s to Sean Mullaney.
Zinkeng (audience): I worked for a state employer, so I’ve got, in addition to the match, I’ve got a 457(b), I’ve got a 403(b) as well. I maxed those out. And I put it pre-tax, which is what we call traditional.
But I’ve been having second thoughts over the years. I’ve never really optimized my Roth IRA. I’ve just been slacking to do the back door Roth. I was contemplating maybe I could put money there after-tax.
Sean Mullaney: For those who are at the highest earning years of their career and are thinking about a potential early retirement, I really like taking the deductions. All this is, is tax rate arbitrage. There are many Americans who at least have some hope of getting to retirement before collecting Social Security. Take those deductions, take the bird in the hand, and you then have runway before turning age 70 where, hey, you know what, we’re going to be in an artificially low tax rate. Let’s go ahead and do some Roth conversions now.
Maybe in our working years, we’re paying 24% federal marginal rate. Plus, maybe if we’re in California, 9.3% marginal state rate. We’re getting 33 cents on the dollar – plus - when we do traditional deductible contributions. And our hope is, and there’s no guarantee here, but we have a reasonable hope that when we get to retirement, before we collect Social Security and maybe even during some of our Social Security years, our income is going to be artificially low. And, so what we do is we fill up maybe the 10% or 12% federal income tax bracket, for some maybe even the 22% bracket, with some Roth conversions. And, we deduct it at 33% federal and state. And then maybe we include at 14%, 18% federal and state when we do those Roth conversions. I can’t speak to any one particular case, but I will say I like the “deduct, deduct, deduct.”
And then this issue also appears on, “oh hey, should I do a Roth 401(k) or backdoor Roth IRA?” In a very general sense, the backdoor Roth has very little opportunity cost because you have two options for that money. You either do a backdoor Roth, assuming you qualify to do it efficiently, or you invest it in a taxable brokerage account. Those are basically the two options.
When you do a Roth 401(k) at work, there is an opportunity cost. Because you can put a dollar into a Roth 401(k), or you can put that dollar into the traditional 401(k). There’s a cost of doing the Roth 401(k) at work: you forgo a deduction. Doesn’t make it the wrong decision, but it means there’s a real opportunity cost on the table. Versus backdoor Roth IRA, most Americans who are doing a backdoor Roth IRA do not qualify. There are some fact patterns where you could deduct it. But, for most Americans who are doing that backdoor Roth, they don’t qualify to take a deduction for a contribution to a traditional IRA. So, there’s not that opportunity cost.
For many Americans, the dynamic duo is “deduct at work - 401(k) traditional - and then Roth IRA or backdoor Roth IRA at home on the individual side.”
Jon Luskin: Sean, let’s talk about the ‘Solo(k)’ trap. Can you tell us what the ‘Solo(k)’ trap is and what solopreneurs need to be thinking about with respect to funding their Solo 401(k)?
Sean Mullaney: The Solo 401(k) trap is this issue where the Solo 401(k) interacts with what’s called the qualified business income deduction. Many solopreneurs qualify to take a deduction of up to 20% of their so-called qualified business income against their taxable income. It’s a unique deduction. It only started in 2018. The interaction between Solo 401(k) and the qualified business income deduction hasn’t been around all that long.
And so what happens is, I get the qualified business income deduction against my Schedule C income. And what I’m going to do is I’m going to do a $10,000 deductible contribution to my Solo 401(k). Don’t I get a $10,000 tax deduction? It turns out you only get an 80% deduction for that. You only get an $8,000 tax deduction because yes, you lower your taxable income by the $10,000 for the Solo 401(k), the traditional contribution, but you also lower your qualified business income deduction by $2,000. One deduction is $10,000. That’s great. But then another deduction, the QBI deduction, is reduced by $2,000. So, it nets out to $8,000.
There are two potential paths that we can then take. One path is, “oh, I don’t like that. I don’t like reducing my QBI deduction. I want to optimize for QBI. So, what I’m going to do is I’m going to go to that Roth Solo 401(k).” Perfectly viable path. You want to think about your future and when might you retire, what might your tax rates be in retirement?
The second path, especially for those in the FIRE movement, might be to lean in and say, “Okay, I get it. I’m going to take a tax deduction for a traditional Solo 401(k) contribution, $10,000. It’s lowering my QBI deduction by $2,000. So, it’s a net $8,000.” So, if I think about a marginal tax rate, maybe today I’m at 24% federal marginal rate. This essentially reduces the marginal rate on that deduction to 19.2%, I believe by my math, 80% of 24%. “But you know what? I’m going to do those Roth conversions in early retirement at 10% and 12%.”
The other thing I’ll point out, this is in the book as well, for certain high-income professionals, the opposite is true. You may want to favor the traditional deductible, because you’re not in the Solo 401(k) trap; you’re in this spot where your income is so high that you’re losing the QBI deduction and then the Solo 401(k) can rescue it. By contributing to the Solo 401(k), you do two things. You get the deduction for the Solo 401(k), and you open back the door to the QBI deduction.
I have an example, a single lawyer, a $61,000 Solo 401(k) contribution that’s deducted not only creates that deduction, but also adds something like $30,000 or $33,000 in QBI deduction. You get a $93,000 tax deduction for paying yourself $61,000 into a Solo 401(k). That seems like pretty good tax planning. But that tends to only occur at the upper levels of income. I have a whole chapter on QBI deduction and how that interacts with Solo 401(k) in the book. There are some very interesting interactions there.
Jon Luskin: For folks who want to check out Sean’s article on the ‘Solo(k)’ trap, AKA the QBI deduction reduction, they can check out his website fitaxguy.com, and then Michael Kitces also has an article on that subject on the QBI reduction. And I’ll link to that in the show notes for our podcast listeners.
Sean, let’s talk a little bit more about this ‘Solo(k)’ trap. At what point is that income so high it makes sense to make traditional contributions to get your income low enough to requalify for the QBI deduction?
Sean Mullaney: You need to look at the current year Section 199(a). That’s where the qualified business income deduction resides in the Internal Revenue Code. Every year the IRS comes out with phase out numbers. They’re adjusted for inflation. So, hopefully, for 2023 they’ll even be higher. The IRS comes out with these phase-out numbers, and I think for 2022 for a single person, it starts at $170,000 and change of taxable income. It’s based off taxable income, not on Modified Adjusted Gross Income. Tax nerds will know the difference there. It phases out a little over $220,000 of taxable income. So, if you’re in those ranges or can get from above $220,000 to at least in that range, you could use a Solo 401(k) to really juice your tax deductions. You can get essentially two deductions for one Solo 401(k) contribution. One, the Solo 401(k) deduction itself. And then two, the expanded or opening the door to the QBI deduction.
And I think for ‘marrieds’, the phase out is between $340,100 - the IRS updates this every year – and $100,000 more, $440,000. You need to think about where am I in my income? And if I’m well below those numbers, I’m almost certainly going to be in the Solo 401(k) trap, but if I’m above those numbers, I might be in this case where, “oh boy, a maxed out Solo 401(k) could really have some significant benefits.”
Jon Luskin: So, with respect to this ‘Solo(k)’ trap and the potential to get some of those QBI deductions back by making the maximum traditional contribution to that Solo 401(k), what are some tax planning considerations? Is it going to be something like, “hey, the year is over, 2022 is at an end, now it’s January 2nd, 2023, and I can figure out what my profit is for the year. Now, I can decide if I want to make a traditional or a Roth, or possibly an after-tax converted to a Roth, or just make profit-sharing contributions from the employer side at that point.” Is that an option for folks to try and take advantage?
Sean Mullaney: The Solo 401(k), unlike its SEP IRA cousin, requires some more upfront planning. And that really applies in two contexts at least. There’s more, but two main ones.
One is formation. In order to make those employee contributions to a Solo 401(k), the Solo 401(k) itself has to be established by year-end. That’s a big one. The SEP IRA does not have that limitation. Now, the SEP IRA also doesn’t have employee contributions to begin with. But you can’t make an employee contribution, like I said, $20,500, up to $27,000 if you’re 50 or older. So, getting that Solo 401(k) set up before year-end is imperative, especially for self-employed, S Corp, whatever your setup might be, assuming you qualify, of course.
And then the second thing is for the self-employed, those employee contributions need to either be made or elected by year end as well. You can’t just get to January 1st and say, “Oh, okay, now I’ll deal with last year’s tax matters, and I will figure out, and I’ll max out the Solo 401(k).” You really needed to be doing some planning. I tend to advocate for early to mid-October. Start learning about this in early October so that early/mid/late October, they can really start thinking about doing this planning.
[00:32:52] If I’m a solopreneur and I’m new to the Solo 401(k), in October I’m going to think about this year’s income and expenses. What do I think November and December look like? Have I set up my Solo 401(k)? All right, maybe now is the time to do it because, look, it’s possible to do it in December, but you don’t want to be the person on the phone in December trying to get that thing set up. There’s that term ‘execution risk’. I’ve seen that happen where, can we get the right EIN in time, and maybe the IRS shuts down their EIN portal - that happened one year - having some attention to this particularly October’s a great time to focus on the Solo 401(k).
Jon Luskin: Sean, with respect to the amount contributed has to be elected beforehand, but not made. Does the tax treatment have to be elected as well? Can you say, hey, I want to do $20,500, and then come January 2nd I can decide if I want that to be traditional or Roth?
Jon Luskin, your Bogleheads® Live host jumping in for a post-episode edit. After the show, Sean Mullaney let me know that to his knowledge, the IRS has never issued guidance on this particular issue and thus taxpayers should consult their own advisors regarding this issue. And, now back to the show.
Sean Mullaney: In many cases, the election is something to the effect I’m going to elect to make a contribution to the maximum extent allowed. In terms of, maybe it’s a traditional contribution, it’s a Roth contribution. Now, the good news is, hey, if you’re in October, you’ve got plenty of time to figure that out.
The employer contribution does not need that election. The employer contribution’s very flexible. The rules that the SEP IRA had. The SEP IRA says, okay, you have to get that contribution in by the tax filing deadline. There’s no particular election that needs to happen. You get to April 15th. You file an extension for Schedule C, you’re now at October 15th. So, the employer piece doesn’t need to be elected. Basically, it just needs to be made by the tax return filing deadline, including any made extensions. But the employer piece on the Schedule C needs to be made - the election or just the flat-out contribution - needs to be done by 12/31.
And then on the S Corp context: So, we haven’t talked too much about that. I’ve got a whole chapter on S Corp’s in the book. The S Corp basically needs to be made with your year-end payroll, or it can be done in January, right? As you issue yourself payroll, the corps issue their owner shareholders who work in the business payroll during the year, and that payroll, just like at a regular W-2 job, can be contributed as an employee deferral into a traditional or Roth Solo 401(k).
Jon Luskin: Plan establishment deadline 12/31?
Sean Mullaney: Absolutely. Yeah. The Secure Act of 2019 changed that for the employer contributions. So, it used to be that even for the employer contribution, the plan had to be established for December 31st. But now the plan can be established after year-end, and the employer contribution only for that year, for the previous year, can be made even though the plan was established after year-end. That’s a Secure Act change in 2019.
For plan establishment, it could be established the next year, but for employee contributions, it’s got to be established by December 31st.
Jon Luskin: Plan establishment at 12/31. Employer profit sharing contribution is the tax filing deadline. And then those employee deferrals and then those after-tax contributions. Deadlines for those are also the tax filing deadline, is that correct?
Sean Mullaney: In the S Corporation context, after-tax contributions would have to be done with payroll during the year.
Jon Luskin: Here’s another post-show update regarding Schedule C after-tax contribution deadlines. Sean shares that his initial read of the regulations requiring the year-end election with respect to employee deferrals does not appear to apply to after-tax contributions. However, as always contribution deadlines are an issue to consult with individual advisors to determine the deadlines applicable to their own unique circumstances.
Sean Mullaney: And then the other thing too, on all these deadlines is work with your plan provider. There are plenty of resources out there on the internet, there’s IRS publication 560 is a really good resource. It’s not perfect, but it’s a really good resource. You should always also just coordinate with your plan, because plans have slightly different rules than the tax rules.
Jon Luskin: Here is a question from the Bogleheads® forums from username ‘uclalee’ who writes:
“I’ve seen a lot of questions about calculating allowable employer and employee contributions for yourself on running a ‘Solo(k)’, but I haven’t really seen much about where they’re documented on tax forms. I haven’t employed spouse under my ‘Solo(k)’, so I assume her employer contributions go on Schedule C, but what about employer contributions for myself? Thanks.”
Sean Mullaney: For the Schedule C employee, the Solo 401(k) deduction is not reported on Schedule C. It is reported on Schedule 1 of the tax return. And the reason for that is the Solo 401(k) is a great tax superhero. It defeats many tax villains, but one tax villain the Solo 401(k) cannot defeat is the self-employment tax. So that’s why it’s not a deduction for the owner-employee. It’s not a Schedule C deduction; it’s a Schedule 1 deduction.
In terms of when you have a spouse in the business, there are different ways to report that. So sometimes, you issue the spouse a W-2. Sometimes the spouse gets their own Schedule C. So, that’s going to really depend on how that’s done is really going to impact the tax return reporting.
Jon Luskin: Sean, this one is from username ‘SuzBanyan’ from the Bogleheads® forums who writes:
“We see a lot of posts here on the Bogleheads® forums from people who ask for help after making an excess deferral or contribution to a ‘Solo(k)’. Usually, this is because the business owners want to front-load the funds and then the earnings don’t justify the amount deferred. Is there a best and or simplest practice for sole proprietors to follow to put funds into the 401(k) as early as possible without risking an excess deferral contribution situation?”
Sean Mullaney: There’s a couple rules to keep in mind here. The first rule is Solo 401(k)s, unlike a Roth IRA or traditional IRA, cannot be prefunded. So, what do I mean by that? So, you get up on New Year’s Day, right? You’re watching the Rose Bowl. You didn’t go to work, you didn’t make any money, but you’re like, yeah, I’m going to make $7,000, $6,000, whatever the limitation is this year. I’m going to go into vanguard.com and make my Roth IRA contribution for the year, or start my Backdoor Roth. No problems, do it New Year’s Day, that’s what you do.
Solo 401(k) doesn’t work that way. There’s a special rule that says for Schedule C self-employed people, your self-employment income for this purpose is payment for services rendered during the year. So, you have to wait to start collecting income to make Solo 401(k) contributions.
And then the question becomes too, is well wait a minute. I got to validate these contributions at year-end. Couple ways to skin that cat. I like to be conservative, but if you’re like, look, I made $300,000, I collected a $300,000 taxable invoice from my client in March. I clearly meet these limitations. Yeah. Then, generally speaking, go ahead and make the contributions.
You do want to be conservative on that. I even talk about an example in the book where maybe you could elect out of something like bonus depreciation and get your income higher for that particular year to support a previously-made Solo 401(k) contribution. So, there can be some planning in that regard. I do think sometimes you’ll see out on the internet, front load your retirement plan contributions because - or convert Roth conversions - because time value of money. I don’t lose too much sleep over that. If you just want to do it after year-end, you filed the election on the employee contributions, it can all work out just fine.
The one thing you do want to do early in the year is get a draft of your Schedule C going. So, we close out 2022. We’re in January, February of 2023. That’s a great time to work with your tax return preparer just to get a good working draft of the Schedule C. Not that every “i” needs to be dotted and every “t” needs to be crossed, but we just get a good working draft. And then we say, “okay, what are the limits on our contributions versus what are the contributions we already made?” There’s a way to pull out those excess contributions. But, generally speaking April 15th is the deadline on that. So that’s why I say let’s get that Schedule C in as good a shape as possible, but well before April 15th. So, if we had to withdraw some excess contributions, we call the plan provider and we say, “Hey, we’ve got to take a corrective distribution before April 15th.”
Jon Luskin: This one is from Username ‘livesoft’ on the Bogleheads® forums who writes - and this is a super technical one - on Form 5500-EZ, part four, line eight, what are the proper applicable two-character feature codes from the list of plan characteristic codes that a typical individual 401(k) plan administrator, i.e., the plan owner and solo employee, would need to use.
Sean Mullaney: So, I am not in a position to do a detailed dive on how we exactly complete the 5500-EZ, but it brings up a really good point. Anytime you have over $250,000 in all your Solo 401(k)s at year-end, you need to file this form 5500-EZ. It’s not a difficult form, even though that question may lead some to believe it.
When you close out a Solo 401(k), so maybe you stop the self-employment, maybe you go to work for someone else, you’re like, okay, I’m just going to roll this thing into a traditional IRA or direct trustee-to-trustee transfer into a workplace 401(k) at that point. You also need to file this form 5500-EZ.
Jon Luskin: Sean, anything else you’d like to share before I let you go for today?
Sean Mullaney: When you’re a solopreneur, it can be somewhat daunting to think about retirement planning. But the Solo 401(k) is a way to really build up some big tax-advantaged savings and it absolutely can be navigated. It’s an opportunity that I think too many solopreneurs are not aware of, and I’m trying to raise awareness about the opportunities to get some tax deductions and build up retirement savings in a Solo 401(k).
Jon Luskin: Absolutely. Like yourself, I’m a huge fan of the ‘Solo(k)’. I always mention it to folks that I work with when there is an opportunity. Actually, the folks that I worked with yesterday, they had the opportunity to max out that employee deferral, and then make an additional five-figure contribution each for a husband-and-wife couple. Really phenomenal tax-advantaged investing vehicle for those folks with that self-employment income.
Well, that is all the time we have for today. Thank you to Sean Mullaney for joining us today, and thank you to everyone who joined us for today’s Bogleheads® Live.
Next week, we’ll have Meg Bartelt answering your questions about equity compensation. Until then, you can access a wealth of information for do-it-yourself investors at the John C. Bogle Center for Financial Literacy at boglecenter.net.
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