Self Employed? Do You Know About Solo 401k Plans?
Over the years I've been blogging I have included the basics of what my wife and I are doing to plan for our financial future. For many years I have been contributing to a SEP IRA which gives the tax break up front, I also contribute to my Roth IRA, we have an HSA and my wife has a spousal IRA that we contribute to and a Roth with a decent balance but we haven't been contributing to her Roth lately in favor of getting the tax break now.
With Roth accounts of course there is no deduction on contributions but withdrawals are tax free (subject to funds being in the account for at least five years). Roths don't have required minimum distributions either. RMDs are how the government taxes your traditional IRA, you have to take out a small percentage every year starting at age 70.5. The tax owed for IRA distributions isn't necessarily onerous but all things being equal it's preferable to not have to pay it.
I've been thinking more and more about what our finances might look like when we are in our 60's and beyond and have shifted the importance I place on legally avoiding taxes, it is becoming more of a priority for me, or more correctly for the future me. I have always said that I don't plan to retire but have conceded that there aren't too many people looking to hire an 85 year old advisor. Maybe they won't want to hire an 80 year old or 75 year old....I don't know when potential clients will view me as too old to hire but it will happen at some point and I plan on being ready which contributes to why we've always tried to have a high savings rate.
With all of that in mind I have opened a solo 401k plan that I will start funding in 2019. The way TD Ameritrade puts it, you have to open a traditional 401k and then you can open a Roth 401k. You don't have to put money into the traditional but it has to be open. I will be putting all of my contributions into my Solo Roth 401k. The reason for doing this is that the contribution limits for the 401k version of a Roth account are dramatically higher than the regular Roth IRA.
The contributions limits for a Roth IRA are $5500, $6500 if your at least 50 years old. With the Roth 401k the contribution limits for 2018 are $18,500, $24,500 if your at least 50. Even if you can't contribute the full $24,500, if you can put anything more than $6500 in, then you're better off with the Roth 401k.
Here's the kicker, with employer sponsored 401k plans, your employer usually provides some sort of matching benefit dependent on how much you put in. The rule of thumb is always, contribute enough to at least get the maximum match. When you're self-employed, you get to match your contribution with an employer contribution. You can get more details from the IRS but based on income, less a portion of your self employment tax and your employee contribution you can put up to $55,000 into your solo Roth 401k.
If you make $150,000/yr you might not be able to afford to put the full $55,000 in to your Roth 401k but you may want to get you contribution up that high from any taxable savings balances. If you have a taxable account and you invest that bucket of money you will pay taxes on gains and on dividends and interest. By shifting that money to a Roth over some period of years you are putting that money into an account that is not taxable. If something comes up that you need to pay for, you just take it from the Roth, it would be a reportable event but not a taxable event as opposed to selling something in your taxable account and paying taxes on any capital gain.
If every nickel you have is in a Roth, then you're not paying taxes on your assets when you're retired but you got no tax deduction on your contributions. You'll still have tax on Social Security (probably), on any passive income (like income property) and from any sort of side gig like a monetized hobby.
Over the next few years I will move as much of our taxable assets into my Roth 401k along with contributing from earnings such that I take full advantage of the contribution limit. There is a little finesse to this because I still have a ways to go before 59 so we need to preserve some in our taxable accounts for the time being.
It is worth revisiting a concept we looked at a couple of months ago related to Roth conversions. Converting a traditional IRA to a Roth IRA is nominally expensive because it is a taxable event, you owe taxes on the amount converted...mostly. In a year with no earned income you could convert $24,000 of a traditional IRA tax free, $24,000 is the standard deduction. In a simplistic scenario where you're 64, not taking Social Security yet, with your only "income" coming from your Roth, you could convert $24,000 without paying taxes. Even just doing this two or three times could meaningfully reduce what you'd otherwise have to take in RMDs once you turn 70.5.
Starting in 2019 we will still fund our Health Savings Account (HSA) and for now I am leaning toward contributing to my wife's traditional IRA, that plus the HSA is still a nice deduction even if a lot smaller than in past years.
While the context here has been solo 401k plans it also can apply to work sponsored plans, more and more there is a Roth option available. You need to decide what is best for you but keep in mind you can contribute to both subject to the same overall limit of $18,500 or $24,500.
I am certainly not early to this party, not even close but in constantly assessing where you stand, things that are important to you can change and that can be a catalyst learn about something new and then prompt a change to how you do things. My plans for when I am older have not changed but my saving strategy has.