- In a solo 401k, you typically either make contributions into a traditional solo 401k account, or a Roth solo 401k account. For the mega backdoor Roth strategy, we make use of another account: The after-tax account.
- After-tax contributions are undesirable on their own. Contributions are made with after-tax income, so you don’t receive any tax deductions. Unlike a Roth account, withdrawals of any gains in retirement are also taxed.
- There are two purposes for the after-tax account: First, it’s the only way to get additional money into your solo 401k. If you don’t make enough money to hit the yearly contribution limit, you can use after-tax contributions to fill the gap. Second, any after-tax contributions can immediately be converted into a Roth account.
- You could choose to rollover the funds into a Roth IRA, or do an in-plan conversion into a Roth solo 401k.
- Using the mega backdoor Roth solo 401k, you can put in up to $61,000 ($67,500 if age 50+) into a Roth solo 401k for 2022 and up to $66,000 ($73,500 if age 50+) for 2023.
The mega backdoor Roth strategy using a solo 401k allows you to supersize your Roth solo 401k contributions each year.
With a solo 401k account, you’re allowed to contribute up to $20,500 in 2022 into a Roth solo 401k. If you’re at least 50 years of age, you can contribute up to $27,000. For 2023, you can contribute up to $22,500, or up to $30,000 if you’re 50 years of age or higher. Using a mega backdoor Roth strategy with the solo 401k, you’re able to contribute up to $66,000 entirely into a Roth solo 401k.
Here’s how it works.
The Ocho Solo 401k Plan helps you execute the Mega Backdoor Roth strategy with after-tax and Roth accounts. Learn more here.
Before we begin, download the Solo 401k Handbook: Everything you need to know about the solo 401k in a handy PDF format.
Context around how the solo 401k works
There are a lot of moving parts to a mega backdoor Roth strategy and it can get a little confusing if we dive straight in. Before we break down how it works, let’s cover the essential elements of a solo 401k plan for some context.
In 2022, the solo 401k contribution limit is $61,000 ($67,500 if you’re 50 years of age or older).
You can contribute as both the employer and the employee and can choose whether you contribute into a traditional solo 401k account or a Roth solo 401k account.
- In a traditional solo 401k account, you contribute with pre-tax income. The money you contribute gets deducted from your income tax. You get a tax break now, but you pay taxes on withdrawals in retirement.
- In a Roth solo 401k account, you contribute with after-tax income. The money you contribute is not deducted from your income tax. You don’t get a tax break today, but you pay zero taxes on withdrawals in retirement.
Only the employee side is given the option for Roth contributions. Employers must contribute to a traditional solo 401k.
Here’s how that’s broken down:
- Employees can contribute up to 100% of their income up to a maximum of $20,500 ($27,000 if you’re over 50) for 2022 and up to a $22,500 ($30,000 if age 50+) for 2023.
- Employers can contribute up to 25% (20% if you’re a sole proprietorship, partnership, or LLC taxed as a sole proprietorship) of their income.
That means that you get to put away a maximum of $20,500 ($27,000 if you’re over 50) into your Roth solo 401k account for 2022 and up to $22,500 ($30,000 if age 50+) for 2023. The remaining room left over must be contributed with employer compensation calculated at 25% of income. But remember that employers can only contribute to a traditional pre-tax account; they do not have the option to contribute to a Roth account.
How a mega backdoor Roth strategy works with a solo 401k
Now let’s see what happens when we use the mega backdoor Roth strategy for our solo 401k.
Remember that with our solo 401k, we either contributed to a traditional pre-tax account or a Roth account.
To make this strategy work, we’ll need to make use of another account: The After-Tax Account.
Yes, the Roth account is funded with after-tax dollars as well, but these are TWO SEPARATE accounts and not related to each other.
In an after-tax account, contributions are not tax deductible AND earnings are taxed. In other words, you don’t get a tax deduction when you contribute, and there is no tax-free compounding so you pay taxes on any gains. If your account makes money, that money gets taxed – even though you funded the account with after-tax dollars.
This makes after-tax contributions an unpopular choice. Its only use is as a vehicle to help us implement the mega backdoor Roth strategy, since it’s the only other way to get more money into your solo 401k.
And you could choose to do this in two different ways: The entire amount, minus employer contributions, or just the difference.
The entire amount
Contribute up to the entire amount into an after-tax account.
Let’s say that your business doesn’t make a lot of money. Or, it does make a lot of money but you prefer not to pay yourself high wages. With the mega backdoor Roth strategy, you can contribute the entire amount up to the limit of $61,000 ($67,500 if over 50) for 2022 or up to $66,000 ($73,500 if age 50+) with after-tax contributions. Even with minimal income earned, you’re still able to max out your solo 401k for the year.
Minus employer contributions
Maximize employee contributions into the Roth solo 401k, and then contribute the rest with after-tax contributions.
Let’s say that you contributed the full amount of $20,500 in employee deferrals into a Roth solo 401k for 2022.
Since the 2022 solo 401k contribution limit is $61,000 that leaves you with $40,500 left over in contribution room.
Remember that employer contributions for a solo 401k are calculated by 25% of income (20% if you’re a sole proprietorship, partnership, or LLC taxed as a sole proprietorship). If you were to contribute that amount with employer contributions, you would need an income of $162,000. If you use the mega backdoor Roth strategy, you could only need $40,500 in after-tax contributions. Not only that, but the entire amount can get converted into your Roth solo 401k.
Just the difference
Max out your employee deferrals and employer contributions and fill the rest with after-tax contributions.
Remember in our calculation above, we concluded that you’d need to make at least $162,000 in order to maximize your 2022 contributions.
$20,500 would be made with employee deferrals, and the remaining would get filled using 25% of your income.
But what if you only made $100,000?
$20,500 would get contributed from the employee side, and 25% ($25,000) would get contributed from the employer side.
That’s a total of just $45,500 and you still have $15,500 ($61,000 – $45,500) left over in contribution room.
Using the mega backdoor Roth strategy, you could contribute the remainder with after-tax contributions. And then it would all be transferred into a Roth account.
How the funds get transferred into a Roth account
There are two different ways that the after-tax contributions are moved into a Roth account.
- Rollover your funds into a Roth IRA.
- Do an in-plan conversion into your Roth solo 401k account.
Both transfers are tax-free. Because you contributed with after-tax dollars, the IRS doesn’t require you to pay any taxes on conversions to a Roth account.
Which one should I choose?
It depends on what you want to do with the money. The Roth IRA has slightly different rules than a Roth solo 401k.
Key differences between a Roth IRA and a Roth solo 401k:
- A Roth IRA doesn’t have RMD. You can keep compounding the money without having to take a required minimum distribution. A Roth solo 401k does have RMD and you’re required to start making withdrawals from your account once you reach the age of 73.
- A Roth IRA is not an employer plan, so it lets you withdraw your direct contributions without penalty. In this case, the amount you convert using the mega backdoor Roth strategy is also able to be withdrawn without penalty, regardless of age.
- A Roth IRA does not have the option for you to take out a loan, while the solo 401k account allows you to loan up 50% of your plan value up to $50,000.
How do I get started with the mega backdoor Roth strategy?
To be able to do the mega backdoor Roth strategy, you need three things:
- Your solo 401k plan provider must allow after-tax contributions.
- Your solo 401k plan provider must allow in-service distributions.
- You need to make enough money for this strategy to make sense.
Not every solo 401k plan provider offers after-tax contributions or in-service distributions. If they do, they do specifically for implementing the mega backdoor Roth strategy.
As long as your plan provider offers these options, and you make enough money that it makes sense to contribute the maximum, then you’re able to do mega backdoor Roth conversions.
Here’s what the steps might look like:
- Open a separate bank or brokerage account under the solo 401k plan. Label it as “After-Tax” so it’s identifiable from your plan’s other accounts.
- Make the appropriate contributions into your after-tax account.
- Complete a conversion form to convert the after-tax funds into a Roth IRA or to a Roth solo 401k.
- Move the funds through check or wire from your after-tax account into your Roth IRA or your Roth solo 401k account.
- Issue Form 1099-R to report the conversion to the IRS.
Some solo 401k plan providers, like Ocho, will take care of these steps for you.
Remember that after-tax contributions get taxed on the gains
Any gains in your account are subject to tax.
You should transfer from an after-tax account into a Roth immediately. Do not let it sit because if it starts making money and then you transfer it, it’s a taxable event.
Similar to a “regular” mega backdoor Roth
The mega backdoor Roth strategy is more common with people who have a regular 401k plan at their work.
However, the biggest difference is that since you’re not your own employer, you’re more restricted by the decisions of the company you work for. Many company 401k plans aren’t set up to offer the mega backdoor Roth. With a solo 401k, you have the freedom to choose a plan provider that offers these options.
In addition, with both scenarios, you’re given the same conversion options: Rollover into a Roth IRA or do an in-plan conversion into a Roth 401k. However, the Roth solo 401k gives you complete investment freedom while the regular Roth 401k limits your choices to whatever the company plan offers.
For both regular 401k and solo 401k, the mega backdoor Roth mechanisms are exactly the same, as are the goals of using the strategy. The goal is to put away as much as you can into a Roth account, which gives you huge tax advantages in retirement.
Why choose to maximize a Roth retirement account?
A Roth account gives you no immediate tax savings, but can save you a fortune in taxes owed when you withdraw in retirement. The beauty of a Roth account is that your money compounds tax-free AND withdrawals in retirement are also tax-free. So if you put in $50,000 and it turns into a $1 billion, you owe zero money to the IRS when you withdraw.
If you purchase a $100,000 property through a solo 401k and it appreciate in value to $2 million, you don’t pay any taxes on the gains. If you purchase a rental property, any rental income you make is all yours. You don’t pay any taxes from rental payments or when you decide to sell that property for a gain.
As you can see, a Roth account can save you a ton in taxes over the years, through the magical combination of tax-free compounding and tax-free withdrawals. Using the mega backdoor Roth strategy with a solo 401k is one of the best methods to maximize your Roth retirement account.
No need to open multiple separate brokerage accounts. Ocho’s Solo 401k Plan comes with an integrated investment platform, no-fee robo-advisor, and full support with compliance and plan administration. Learn more here.