Add a Roth Contribution to Your Solo 401(k)

Add a Roth Contribution to Your Solo 401(k)

A good thing ? the Solo 401(k) ? just got a whole lot better.

A Solo 401(k) plan is already a great tax-advantaged retirement savings vehicle for a business (including corporations) where the owners and their spouses are the only employees. In 2006, tax- deductible retirement contributions can be as high as $49,000 per person (assuming you are over age 50 and have sufficient adjusted gross income to qualify for the maximum contribution). Amounts contributed to the plan grow tax-deferred until withdrawn, at which time regular income tax rates will apply.

Starting in 2006, 401(k) plans can be amended to include a Roth contribution option. This permits you to make all or part of the ?employee deferral? portion of the plan contribution ? up to $20,000 for people over 50 ? on an after-tax basis. Even if you are self-employed, technically your 401(k) is funded by a combination of employer contributions and employee salary deferrals; only the employee deferrals can go into the Roth account. The subsequent distributions after you retire are not just tax- deferred; they are tax-free, putting more money in your pocket.

Because it's part of a 401(k) plan, the Roth 401(k) has some notable features that distinguish it from the Roth IRA:
  • High earners can contribute to a Roth 401(k) ? unlike the Roth IRA where contributions phase out for incomes higher than $95,000 single / $150,000 joint (in 2006).
  • You can contribute more to a Roth 401(k) ? up to $20,000 vs. a maximum of $5,000 per year to the Roth IRA.
  • If you need quick cash, you can borrow from your 401(k), but not your IRA.
  • Roth 401(k)s have Required Minimum Distributions at age 70 ?. You can avoid these by rolling your Roth 401(k) over to a Roth IRA prior to age 70 ? . Just remember to setup the Roth IRA at least five years before you need to make a withdrawal, to avoid taxes and penalties.
  • Contributing to a Roth 401(k) does not prevent you from also contributing to a Roth IRA ? raising the annual potential Roth contribution to $25,000, depending upon your income level.
These features make the new Roth 401(k) especially good for:
Young people with low net income
  • Their current low tax bracket means they would get a relatively small benefit from the traditional 401(k)'s tax break now.
  • Their long time horizon until retirement increases their tax-free growth potential.
Individuals with high income
They now have a way to make immediate Roth contributions (income limits on Roth IRA conversions are still in place until 2010).

If you have self-employed income and don't already have a 401(k) plan, consider setting one up. If you already have a 401(k), consider adding the ?Designated Roth Account (DRAC)? option. The sooner you get started, the greater the benefit you will reap from tax-free growth of your retirement savings.