As a self-employed individual, you have several choices when it comes to establishing and making contributions to a retirement plan. These include the following six types of plans:
- Traditional IRA
- Roth IRA
- SIMPLE IRA
- Defined benefit plan
- Solo 401(k)
The type of plan that’s best-suited for a particular situation depends on a number of factors. These include projected contribution amounts, projected pre- and post-retirement marginal income tax rates, projected annual retirement expenses, projected retirement income from other sources, other investment assets, and extended care planning.
Solo 401(k) Plan Basics
The solo 401(k) plan has become a popular choice for self-employed individuals in recent years. Designed for a business owner with no employees and potentially his or her spouse, these plans offer the potential for sizable contributions similar to any other 401(k) plan.
Contributions may include employee, or elective, deferrals and employer nonelective contributions. Employee deferrals may be as much as 100% of compensation capped at $19,000, or $25,000 if age 50 or over in 2019. Employer contributions up to 25% of compensation are also permitted, with a limit of $56,000 for total contributions plus an additional $6,000 if age 50 or older in 2019.
Similar to other 401(k) plans, the solo 401(k) can be designed with two variations for employee contributions: traditional or Roth. Traditional 401(k) contributions are pre-tax with an associated reduction of taxable income. Roth 401(k) contributions are after-tax and as such are nondeductible. Traditional plan distributions are taxable while Roth 401(k) distributions are nontaxable.
Greater Lifetime Withdrawals Possible With Roth 401(k)
As pointed out in How to Put Some Muscle Into Your Roth 401(k), most people don’t think about, let alone analyze, how their retirement plan contributions will convert to after-tax income streams when they retire, especially if they’re in their 20s and 30s. Consequently, they generally favor traditional 401(k) contributions with their pre-tax deduction and immediate income tax savings.
Greater lifetime withdrawals are possible with a Roth vs. a traditional 401(k). This is due to the fact that the income tax liability attributable to withdrawals from a traditional 401(k) will often be much greater than the income tax savings from contributions.
Roth Solo 401(k) Boosted by New Tax Law
The income tax savings associated with a traditional 401(k) contribution is dependent on one’s marginal, or highest, tax rate. The Tax Cuts and Jobs Act of 2017 made two changes to the tax calculation that reduced marginal tax rates for many individuals, making the Roth solo 401(k) a potentially better choice.
First, five of the seven income tax rates have been reduced by 1% to 4% each, with the top rate going from 39.6% to 37.0%. The former 28% bracket, which is now 24%, experienced the largest decrease.
Second, the income brackets to which each tax rate is applied have widened. As an example, suppose that you use married filing joint status and your taxable income is $300,000. Before the new tax law, you would have been in a 33% marginal tax bracket and your 2017 income tax liability would have been $73,726. Under the new tax law, your marginal tax bracket decreased to 24% in 2018 with liability of $60,579, resulting in tax savings of $13,147.
Likelihood of Higher Tax Rates Favors Roth Solo 401(k) Contributions
The reduced tax rates and expanded tax brackets under the new tax law are only in effect through 2025. Higher tax rates are likely in the future given the skyrocketing national debt, currently at $22 trillion, and associated increasing interest payments, increased Medicare and Social Security spending with a growing percentage of the population comprised of retirees vs. employees, and projected shortfalls of the Social Security system.
Given this scenario, higher tax rates are inevitable for many people – even in retirement. Self-employed individuals who make contributions to traditional solo 401(k) and other types of deductible retirement plans will generally experience greater taxable income and tax liability throughout retirement than those who contribute to Roth solo 401(k) plans. Furthermore, taxable required minimum distributions (RMDs) from traditional 401(k) plans must be taken beginning at age 70-1/2.
Increased tax liability will be more likely to the extent that additional funds must be withdrawn from traditional 401(k) and other taxable retirement plans to pay for extended care expenses vs. receiving tax-free income from long term care insurance. Finally, traditional 401(k) participants will pay higher Medicare premiums in many cases since amounts are based on modified adjusted gross income.
The decision to contribute to a Roth vs. a traditional solo 401(k) plan is complicated. It should be evaluated within the context of each individual’s financial situation. Many variables need to be considered, several of which are unknown. It doesn’t have to be an all-or-nothing decision. Contributions may be made to either or both types of plans so long as employee, employer, and total contributions don’t exceed specified limits.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.