While there is plenty of discussion regarding the benefits of a solo 401k, less time has been spent discussing using a Roth. Most people have heard of a Roth IRA, but not a Roth 401k. Many have even asked – is this even possible?
Well, it indeed is possible, and it is under-utilized. Typically, folks who want to maximize retirement contributions have been in higher tax brackets. In most situations, I wouldn’t recommend a Roth at higher tax brackets.
But if you think that tax rates are only going higher or if you believe that you will be in a higher bracket at retirement then a Roth may be a wise choice. It makes more sense to put money into a pre-tax account when you are in the 39.6% tax bracket as compared to the 10% tax bracket.
So what are self-employed people in lower tax brackets to do? This is where a Roth makes a lot of sense.
Roth 401ks are subject to the same employee contributions as normal 401ks. That is, $18,000 for employees below the age of 50 and $24,000 for those 50 and older. Most employers offer Roth 401k elective deferrals, but most employees just don’t take advantage of them.
401k plans have the option to allow Roth contributions. These funds must be tracked separately from regular 401k contributions. As long as the 401k adoption agreement has a Roth component you are in good shape.
Let’s look at an example of a real estate client who was looking to boost his retirement savings.
This client has approximately 50 rental properties. Also, he and his wife have a small amount of earned income as real estate agents.
The rental properties generate passive income for him. But as a result of depreciation expense, he does not have high taxable income. He even completed a cost segregation study on his rentals. His taxable income was only approximately $100,000 a year, but his cash flow was much higher. Good for him.
But for a married couple with two kids and $100,000 a year in taxable income, he finds himself in the 15% tax bracket. Now the 15% tax bracket is certainly not as good as the 10% bracket, but it is a far cry from the 39.6% bracket. At this rate, pre-tax 401k contributions just don’t make as much sense.
For a self-employed person looking to get some money into retirement, a solo 401k is a great place to start. But make sure the plan at least allows for : (1) an elective profit-sharing component; (2) a Roth contribution; (3) rollovers from other plans; and (4) a loan provision. Clients don’t have to utilize all of these components, but at least they are options.
Since the client is only in the 15% tax bracket, they are not facing a huge IRS tax issue. At $100k a year in taxable income, they still can take tax credits for their children and are not faced with phase-outs like higher income earners. That is why the Roth 401k is a great option for him.
Assuming he and his wife can each generate enough earned income to contribute $18,000 each this will get them $36,000 annually. At 43 years old, let’s assume that he does this for 20 more years that is $720,000 and this does not consider any investment returns. At age 65 he and his wife should be able to take out upwards of $60,000 a year and not outlive their money.
Now $60,000 a year may not sound like enough for retirement. But when you consider it is tax-free then it makes a lot more sense. Combined this with social security and income generated from his rental properties he should be just fine.