The Ultimate Guide To After-Tax And Roth Contributions To Your Solo 401(K)

Often “after-tax” and “Roth” are mentioned in the same breath as financial giants.

You might be surprised that these aren’t just tactics for the super-wealthy; in fact, anyone with a Solo 401(k) plan can benefit immensely from them.

A Solo 401(k) plan offers an extremely powerful way for self-employed individuals and solopreneurs to save. With support for after-tax and Roth contributions though, it’s even more powerful than you may realize. 

In this article we’re going to break down how after-tax and Roth contributions to a Solo 401(k) work, how to best leverage them to maximize your savings and minimize your taxes, and more. Dive into our comprehensive guide to unravel these questions, understand the nuanced differences, and strategically maximize your retirement contributions.

Why make after-tax contributions to a Solo 401(k)?

If contributing to a Solo 401(k) can reduce your taxable income (and therefore, your tax bill come April) - what would make after-tax contributions so special? 

It turns out, a lot. While you forgo the benefits that come with paying less in taxes now, there are many benefits to contributing post-tax. The three we will explore are:

• Tax-free growth with a Roth conversion

• Higher contribution limits

• Flexibility in your distribution strategy

Let’s explore each of these in more depth.

Tax-Free Growth with a Roth Conversion Option

One major benefit of after-tax contributions is the fact that they can be rolled over to the Roth side of your Solo 401(k), giving you tax-free gains when you withdraw.

This maneuver is often referred to as a "Mega Backdoor Roth" conversion. When these conversions are done, the amounts rolled over (minus any earnings if the conversion isn't immediate) will have the ability to grow tax-deferred and eventually tax-free if the criteria are satisfied. Then, during retirement, qualified distributions from the Roth Solo 401(k) are tax-free. 

This can be a powerful strategy if you are looking to minimize your tax burden when you withdraw your funds. 

Higher Contribution Limits

As of 2023, the combined contribution limit for a Solo 401(k) is $66,000 for individuals under 50 and $73,500 for those 50 or older. This includes the contributions from the “employer” and “employee” side.

The beauty of after-tax (as opposed to pre-tax or Roth contributions from the employee side), is that they are not subject to the $22,500 limit on the employee side. Instead, they are subject to the overall Solo 401(k) limit, meaning you can contribute more than you would have otherwise. With the ability to convert after-tax contributions to Roth (outlined previously), this presents an immense opportunity to contribute more and save more on taxes.

Since you can convert these after-tax contributions into Roth later on, this effectively allows you to contribute much more to the Roth side than you would have otherwise.

Flexibility in Distribution Strategy

Lastly, having a mix of pre-tax, Roth, and after-tax amounts in retirement accounts gives you greater flexibility in managing your tax situation in retirement. 

For instance, in a year where you might have more taxable income due to unforeseen circumstances, you might opt to take distributions from the Roth side to avoid pushing yourself into a higher tax bracket. Conversely, in years of lower income, you might choose to take distributions from the pre-tax side while staying in a lower tax bracket. This tax diversification strategy allows for more nuanced tax planning in retirement.

Each of these reasons adds a layer of flexibility and potential tax benefits to your retirement planning strategy. 

After-tax vs. Roth contributions 

We covered two types of contributions, after-tax and Roth and you can probably tell that there is a pretty distinct difference between the two. 

Some will use these terms interchangeably ignoring that very important difference between Roth and after-tax; let’s dive in and explore how they differ and their advantages.

Are after-tax and Roth contributions the same?

The short answer is: no, after-tax and Roth contributions are not the same, although they both involve money that's been taxed.

Roth contributions are made with post-tax dollars and grow tax-deferred but eventually may be tax-free. When you withdraw from a Roth account in retirement, the distributions (both contributions and earnings) are generally tax-free after 5 years and reaching one of the qualifying events: attain age 59 ½ , death, or disability. 

On the other hand, while after-tax contributions to a Solo 401(k) also use post-tax dollars, the growth on those contributions is taxed upon withdrawal. Why would you pay taxes twice? Great question: remember above, you can contribute more using after-tax dollars and convert these after-tax dollars to Roth, effectively giving you a higher Roth contribution (and therefore, more in tax-free savings).

Roth contribution limits and rules

As of 2023 the limit for employee contributions (which can be designated as Roth) to a Solo 401(k) is $22,500 for those under 50. Individuals aged 50 and above can make an additional catch-up contribution of $7,500. You can only make Roth contributions from the employee side, so this will be the hard limit for your Roth contributions. 

Roth contributions are made on an after-tax basis. This means you've already paid taxes on this money. In return, the money grows tax-deferred, and distributions during retirement are typically tax-free, provided certain conditions are met (like having the Roth account for at least 5 years and being over the age of 59½, death, or disability).

After-tax contributions limits and rules

The overall limit for a Solo 401(k) in 2023 is $66,000 for those under 50 or $73,500 for those 50 or older (including the catch-up contribution). This total includes both the employee's contribution (pre-tax or Roth) and the employer's contribution. 

After deducting the employee and employer's contributions, the remaining space up to the total limit can be filled with after-tax contributions. Remember though, unlike Roth contributions, the growth on after-tax amounts is not tax-free. When you withdraw these earnings in retirement, they are taxable. The contributions themselves, being after-tax, are not taxed again upon withdrawal.  This is where a good recordkeeping system like SEPIRAks will help keep track of the contributions separately.

Roth and after-tax side-by-side comparison

To help illustrate the difference between Roth and after-tax contributions, here is a quick side-by-side comparison of the two:

  Roth After-tax Taxes on contributions Contributions made after-tax Contributions made after-tax Taxes on withdrawals Withdrawals are tax-free as long as the withdrawal requirements are met Withdrawals are taxed as ordinary income Contribution limits $22,500 plus $7,500 if aged 50 or older $66,000 less any employer and employee contributions NOT including catch-up In-Plan Roth Rollover   Contributions can be converted to Roth

When should you make after-tax vs. Roth contributions?

This guide cannot replace a conversation with a tax specialist or financial advisor, however, we hope this gives you some good food for thought as well as an idea of the scenarios you might want to make these types of contributions.

When to make after-tax contributions

There are two scenarios where it makes sense to make after-tax contributions as opposed to pre-tax or Roth:

• You maxed out your Roth contributions: If you have already contributed up to the limits for the employee (Roth or pre-tax) and employer contributions, after-tax contributions allow you to utilize the remaining space up to the total Solo 401(k) limit.

• Mega backdoor Roth potential: Those who wish to take advantage of the "Mega Backdoor Roth" conversion see after-tax contributions as the stepping stone. This strategy involves periodically converting these after-tax funds to Roth, allowing for even more money to benefit from tax-free growth than the standard Roth contribution limits would permit.

When to make Roth contributions

On the other hand, here are two scenarios where Roth contributions may make the most sense:

• You anticipate higher taxes in the future: If you believe that your tax rate during retirement will be higher than your current rate, Roth contributions are ideal. You pay taxes now, at a presumably lower rate, in exchange for tax-free distributions in retirement.

• You want to avoid taxes on earnings: The beauty of Roth contributions lies in their simplicity: your money grows tax-free, and qualified withdrawals are tax-free. There's no need to worry about future tax implications on these funds.

Always assess your short-term and long-term goals and consult a tax professional or financial planner to tailor your strategy to your specific circumstances.

Record-keeping requirements and best practices for after-tax contributions to your Solo 401(k) plan

If all these benefits sound too good to be true, let us assure you they are not; however they do come with a caveat: record keeping. 

In order to stay compliant with the IRS, you need to ensure that you keep sufficient records of contributions and rollovers during the duration of your Solo 401(k) plan. There are numerous records that need to be kept for a Solo 401(k) plan:

• Contribution records: For every contribution made (whether pre-tax, Roth, or after-tax), keep records of the amount, date, and type of contribution. This can be useful for tracking annual contributions against IRS limits and for determining the taxable amount of distributions down the road.

• Rollover documentation: If you roll over funds between accounts (like executing a Mega Backdoor Roth), maintain documentation that shows the origin of the funds, the amount, the date of the rollover, and the destination account. This helps verify that rollovers were executed properly and within allowed limits.

• Document storage and digital backups: In today's digital age, consider keeping electronic backups of all important documents. Cloud storage or secure digital mediums can prevent the loss of vital records due to physical damage or misplacement.

If this is starting to make your head spin, don’t worry: if you have a Solo 401(k) plan through SEPira(k) then we provide you with everything you’ll need to keep your plan’s information and records in order and stay compliant with the IRS.

Sign up for a plan today. It takes minutes to start saving and it will save you years (and many headaches) down the line.

Frequently Asked Questions:

We covered a great deal in this article, however, there are a few common questions still worth addressing. 

What’s a backdoor Roth and mega backdoor Roth?

A backdoor Roth refers to a strategy where individuals, who earn too much to contribute directly to a Roth IRA due to income limits, first contribute to a traditional IRA and then convert that amount to a Roth IRA. The Mega Backdoor Roth, on the other hand, involves making after-tax contributions to a 401(k) plan and then converting those after-tax dollars to a Roth 401(k) or rolling them into a Roth IRA. Both methods offer a way to get funds into Roth accounts where they can grow tax-free.

Can I do a backdoor Roth with a Solo 40k?

Yes, the Solo 401(k) can be part of a backdoor strategy in two ways. 

First, if you have pre-tax funds in a traditional IRA (which would interfere with a regular backdoor Roth IRA contribution due to the pro-rata rule), you can roll those funds into a Solo 401(k) to clear the way. 

Secondly, the Solo 401(k) allows for the Mega Backdoor Roth conversion by making after-tax contributions and then converting them to the Roth component of the plan or rolling them into an external Roth IRA, provided the plan document allows for it.

How can I get started making Roth contributions to a Solo 401(k)?

Ready to start making after-tax and Roth contributions to a Solo 401(k) plan? You’ll need to set up a Solo 40(k) plan with a provider that supports after-tax and Roth contributions (along with Roth conversions). SEPira(k) supports this, along with a record-keeping system that allows you to keep track of your contributions and stay compliant with the IRS. 

Set up your plan today.