One of the biggest advantages of a solo 401k is that you have more flexibility in how you contribute to your plan. However, this can also cause some confusion if you’re making contributions for the first time.
When you open a solo 401k plan, you’ll see several contribution types.
- Roth Post-tax
- Traditional Pre-tax
- Optional After-tax
If you’re unsure what each one means, it helps to first understand the difference between employee and employer contributions.
Employee vs employer
With a solo 401k, since you’re the owner of your business, you get to make contributions as both the employer and the employee. Contributions to both sides add to up fill the yearly solo 401k contribution limit, which is $66,000 for 2023 ($73,500 if age 50+).
Employee and employer contributions each have their own separate rules.
- Can either be traditional pre-tax or Roth post-tax, or both.
- Has a limit of $22,500 ($30,000 if age 50+) in 2023.
The maximum amount you can contribute as an employee is $22,500 for 2023. If you’re over 50, you also get an additional $7,500 in catch-up contributions, bringing your limit to $30,000. With employee contributions, you also get to choose if you want to contribute as traditional pre-tax or Roth post-tax (explained further down below).
- Can only be traditional pre-tax. Employers cannot contribute to a Roth account.
- Can contribute up to 25% of compensation if the business is incorporated, and 20% if the business is not incorporated.
Employer contributions have no set limit, but total contributions between employee and employer must not exceed the solo 401k contribution limit of $66,000 for 2023 ($73,500 if age 50+). If you max out your employee contributions, which has a limit of $22,500, you’ll be left with $43,500 in room remaining for employer contributions.
Employer contributions are calculated as 25% of compensation (approximately 20% if your business is not incorporated). So if you make $100,000, you’re able to contribute $25,000 as an employer if your business is incorporated, and ~$20,000 if your business is not incorporated.
Should I prioritize employee or employer contributions?
There are no rules on where contributions need to be made first. For example, you could choose to make all of your contributions as an employer, and not make any contributions to the employee side for the year.
There are two things to consider:
1. Do you want to contribute to a Roth post-tax account?
Since employee contributions can either be traditional pre-tax or Roth post-tax, but employer contributions can only be pre-tax, if you want to make contributions as pre-tax, it may make more sense to contribute as an employer first. That way, your employee limit doesn’t get used, and you still have the full Roth limit available should you decide to contribute more money.
2. Tax deductions
Since you can make pre-tax contributions to both the employer and employee side, one important consideration is where you want to deduct taxes from. Employer pre-tax contributions may be tax deductible on the business’ tax return, whereas employee pre-tax contributions may be tax deductible on the individual’s tax return.
Pre-tax vs post-tax
Traditional pre-tax: With a pre-tax contribution, you’re choosing to get a tax break now rather than later, since contributions to a pre-tax account get deducted from your taxable income. For example, if you made $60,000 this year and choose to contribute $20,000 to a pre-tax account, your new taxable income is now $40,000. The downside is that when you make withdrawals from your account in retirement, it’ll be taxed as regular income.
Roth post-tax: With a post-tax contribution, you’re choosing to pay taxes now in return for tax-free withdrawals in retirement. If you made $60,000 this year and choose to contribute $20,000 to a Roth account, your taxable income is still the full $60,000. You contribute to your account with money you’ve already paid taxes on. The upside is that when you make withdrawals in retirement, it’s completely tax-free.
As mentioned earlier, employee contributions can be pre-tax and/or post-tax. Employer contributions can only be pre-tax.
Which one should you choose?
With a solo 401k, you’re able to mix and match, and choose different allocations each year.
If you’re in a high tax bracket today and want to reduce your taxable income for the year, a pre-tax contribution may make more sense, especially if you believe you won’t be in a high tax bracket in retirement. If you’re okay with paying taxes today and prefer to take tax-free withdrawals in retirement, a post-tax contribution may be the preferable choice. The main consideration is whether you want to get taxes out of the way today or defer them until retirement.
The contribution type you choose is not an all or nothing decision. You can choose to allocate a certain percentage to pre-tax and the rest to post-tax.
For example: Let’s say you decide to contribute $20,000 to a solo 401k and want to maximize Roth contributions since you prefer tax-free withdrawals in retirement. However, you also notice that reducing your taxable income by $5,000 would bring you down a full tax bracket. In this case, you may decide to put $15,000 into a Roth account for the year, and the other $5,000 as pre-tax so that you’ll be bumped down a tax bracket.
Both pre-tax and post-tax accounts provide tax-free compounding, meaning you don’t pay any capital gains tax when you sell assets in your account or earn an income from them (ie. if you invest in a rental property through your solo 401k and earn income through rent payments).
Therefore, the potential gains from your investments are also something to consider when choosing between pre-tax and post-tax contributions.
For example: Let’s say that John and Jane both decide to contribute the exact same amount into their solo 401k, and their investment gains are equal. They both contribute $50,000 into their solo 401k plans – John makes all of his contributions into a pre-tax account, and Jane makes all of her contributions into a Roth account. In retirement, their investments in their solo 401k have grown to a value of $2 million.
Because John contributed to a pre-tax account, he’ll have to pay regular income taxes when he makes withdrawals. He’ll be taxed based on his tax bracket and tax rates at the time of withdrawal. Because he doesn’t want to pay a ton of taxes all at once, he decides to spread his withdrawals over the next 12 years.
Jane, on the other hand, isn’t obligated to pay any taxes when she withdraws the $2 million from her account since she contributed with post-tax money into a Roth account. She can withdraw the entire amount all at once, or keep the money compounding in her account until she’s required to take withdrawals at the age of 73, which is the age RMD kicks in.
What is the optional after-tax account?
The after-tax account is an optional account, separate from the traditional pre-tax and Roth post-tax accounts. Contributions are made with after-tax income, so you don’t receive any tax deductions. But unlike a Roth post-tax account, withdrawals of any gains in retirement also get taxed.
The after-tax account should only be used when you want to implement a mega backdoor Roth solo 401k conversion, a method to put more money into your Roth solo 401k than is typically allowed by the IRS. Unless you’re looking to do a mega backdoor Roth conversion, this account can mostly be ignored.
Here’s how it works: After contributing money into your after-tax solo 401k, it gets immediately converted into your Roth solo 401k. You’re normally allowed to contribute up to $22,500 in 2023 into a Roth solo 401k. If you’re at least 50 years of age, you can contribute up to $30,000. Using a mega backdoor Roth strategy with the solo 401k, you’re able to contribute up to $66,000 ($73,500 if age 50+) entirely into a Roth solo 401k. And because contributions were made with income that you already paid taxes, transferring it to the Roth post-tax solo 401k is not a taxable event.
- With a solo 401k, you can contribute as both the employee and employer.
- Employees can contribute up to $22,500 in 2023 ($30,000 if age 50+).
- Employers can contribute up to 25% of their compensation if incorporated, and approximately 20% if not incorporated.
- The total employee and employer contributions must not exceed the solo 401k contribution limit, which is $66,000 for 2023 ($73,500 if age 50+).
- Employee contributions can be pre-tax or post-tax (Roth), while employer contributions can only be pre-tax.
- Pre-tax contributions get deducted from your taxable income, allowing you to pay less taxes the year you contribute. However, withdrawals in retirement are taxed as regular income.
- Post-tax contributions are made with income you’ve already paid taxes on. You don’t get any immediate tax breaks when you contribute, but withdrawals in retirement are completely tax-free.
- You can mix and match your contributions, and choose different allocations each tax year.