Posted over 4 years ago

Pretax Solo 401k Contributions vs. Roth Solo 401k

"The question isn't at what age I want to retire, it's at what income." ~ George Foreman

Retirement is a distressing topic in our country. If you are an active internet user, it is quite likely that you would have come across multiple retirement crisis reports. Our team decided to look into the recent government data and our results were quite similar.

According to a May 2015 report from the United States Government Accountability Office, at least 27% of all the households aged between 55 and 64 have no retirement savings or defined benefit plan. What's even worse is that the other end of this spectrum involving 59% of the households having some retirement savings isn't doing pretty well either. They have median retirement savings of $104,000, which turns out to be an inflation-protected annuity of $310 per month for a 60-year old.

It is quite evident that a large portion of our population has inadequate retirement savings. When it comes to retirement savings, in addition to the time of investment period, the type of retirement contributions you make has a huge impact over your retirement fund.

With Solo 401k and self-directed IRAs as our primary products, we get questions about pretax and Roth contributions all the time. Sensing a growing interest in this subject, we have put together a comparative analysis of pretax and Roth contributions. However, before getting into that let us start with a primary introduction of a Solo 401k plan.

What is a Solo 401k plan?

Solo 401k is an IRS approved retirement plan for owner-only businesses and self-employed professionals. It combines the power of higher contributions and flexible investments into a single plan, allowing self-employed individuals create a sizeable retirement nest egg.

Key benefits of Solo 401k Plan

  • Higher contributions: The maximum you can contribute up to $59,000 for 2016 and if your spouse is involved in the business, he/she can make an equivalent contribution as well. These contribution limits are at least ten times higher than the traditional IRA limits of up to $6,500.
  • Flexible investment options: A self-directed Solo 401k comes with numerous investment options, starting with real estate, mortgage notes, tax liens, tax deeds, precious metals, private equity, and hard money lending along with traditional stock and bond investments.
  • Participant loan: The IRS allows a participant loan of up to $50,000 or 50% of the account balance per plan participant. Participant loans are available at affordable interest rates (prime rate + 1%) and comes with no credit eligibility criteria.
  • Roth Solo 401k account: Unlike traditional IRAs, there are no income restrictions for contributing into a Roth Solo 401k plan. This could be a crucial feature for professionals with high income limits.

How does pretax and Roth contributions affect your retirement savings?

Case I

Ron, 30 years old and with an annual income of $80,000, decided to contribute $18,000 annually to his Solo 401k plan until the regular retirement age, 60 years.

For simple calculations, we'll assume that Ron falls under the same tax bracket during his retirement, i.e. 25%, although when calculating with the current tax brackets, his effective taxation rate comes out to be 20%.

Investment returns= 8%; Current tax rate= 25%; Tax rate during retirement= 25%; Net contributions = $540,000; Age of retirement= 60 years; reinvestment of any tax savings generated by traditional contributions.

Upon calculating both pretax Solo 401k and Roth Solo 401k contributions for Ron, here are our findings.

Pretax Solo 401k Fund: With the above investment terms and pretax contributions, Ron will end up with a retirement fund of $1,962,036.

Roth Solo 401k Fund: With Roth contributions and the same investment terms, his retirement fund will grow up to $2,126,420.

Case II

Melinda, 45 years old with an annual income of $60,000, decided to contribute $15,000 annually to a Solo 401k until the regular retirement age, 60 years.

In this case, we'll assume that Melinda falls to a lower tax bracket of 15% during her retirement.

Investment returns= 8%; Current tax rate= 25%; Tax rate during retirement = 15%; Net contributions= $225,000; Age of retirement= 60 years; reinvestment of any tax savings generated by traditional contributions.

Upon calculating both pretax Solo 401k and Roth Solo 401k contributions for Melinda, here are our findings.

Pretax Solo 401k Fund: With the above investment terms and pretax contributions, Melinda will retire with a fund of $451,111.

Roth Solo 401k Fund: Keeping the investment terms similar with Roth contributions, Melinda will have a retirement fund of $424,723.

Pretax Contributions: What should you know?

  • Higher take-home pay & current tax savings: If you choose pretax contributions, your take-home pay will be higher, courtesy of the current tax savings, along with a lower tax bill.
  • Pay regular income taxes on withdrawals: With pretax contributions, you are choosing to pay regular income taxes during retirement. Keep in mind that your income level is likely to either go up or down during retirement, and paying income tax with a reduced income could demand strict lifestyle changes.

However, as depicted in our above example, a pretax contribution method could leave professionals nearing retirement with more money as compared to a Roth plan, especially if they fall under a lower bracket during retirement. The age at which you start contributing will have a huge impact over your nest egg.

Roth Contributions: What should you know?

  • Lower take-home pay with possibly tax-free withdrawals: Under a Roth contribution plan, you will pay taxes as per your current tax rate with a possibility of tax-free withdrawals during retirement. Make sure to hold the account for at least five years and take withdrawals after 59½ years only.
  • Withdraw earnings tax-free: Much like a regular Solo 401k plan, any earnings from your retirement investments made within a Roth Solo 401k fund grow tax-free; however, a Roth account offers tax-free withdrawal of these earnings. It could be a game changer considering that these earnings could add up over the next two or three decades.

However, keep in mind that there are a couple of conditions you need to fulfill for tax-free withdrawals.

Hybrid Approach: Combine Pretax Contributions With Roth

If you are just starting up with retirement savings or have a pretax Solo 401k contribution plan, switching to a Roth Solo 401k could be challenging. The key is to start small, and instead of going with any one of these plans, you can opt for a hybrid approach.

The IRS allows cumulative annual contributions of up to $24,000 for 2016, which means you can contribute in multiple accounts. It will allow you to adjust to the additional tax burden, and you can start with a 50-50 approach.

Additional Benefit of a Hybrid Approach

Hybrid contribution approach has another advantage, which is the more common reason investors choose to have both accounts. The benefit is that during retirement, you can choose whether to withdraw from a Roth or pretax account. If your income is high for a particular year, and you're in a higher tax bracket, you might want to withdraw from a Roth to lower taxes. On the contrary, if your income drops that year (stock market drops, less dividend earnings, etc), then you can withdraw from pre-tax and pay less taxes on the money.

The biggest advantage when saving for retirement is time, so start saving as early as possible. When it comes to financial decisions, it is best to seek expert advice and devise a strategy that aligns with your future goals.

Comments (4)

  1. I've just started learning about solo 401k's and this article has been a HUGE help!

    I have a question regarding this bit:

    • Taxes and penalty in case of a delinquency: For some reasons, if you’re unable to repay the loan and it goes under delinquency, the entire loan amount will be considered as a taxable distribution. Further, if you’re under the age of 59 and a half years, you will trigger an additional 10% penalty for early distributions.

    Are you saying that anyone under the age of 59.5 years will have a 10% tax, or does that only apply to those under the age of 59.5 years that are delinquent?

    I'm under that age and a 10% tax that applies even if I'm not delinquent would certainly turn me off to a solo 401k. Everything else I've read seems good for me so far, though.

    I'm just not sure if I'm better off taking my extra W-2 income and paying more towards the principal on my primary residence in order to qualify for a home equity loan sooner, OR putting my extra W-2 income in a solo 401k and getting my next loan that way. Any advice as to which might be the better move for me?

    Paying more towards my home loan saves me interest on the loan. Paying more towards the solo 401k saves me income tax. If it helps, I'm talking about 1-3 thousand dollars per month.

    Maybe there's another, more creative option I'm missing completely...?

    I want to be able to shop for a BRRRR property ASAP AND pay less income tax on my day job if at all possible.


  2. > The IRS allows cumulative annual contributions of up to $24,000 for 2016

    I think it should say that the limit is $18,000 for 2016, unless you're over age 50, then it's $24,000.

    1. Jim, you are correct, the max contribution limit is $24,000, which includes $6,000 in catch-up for those who are over 50. You are getting pretty good handle on the rules :-)