The Self Employed Roth 401k is a retirement plan for the self employed that allows non tax deductible salary deferral contributions that grow tax free and are withdrawn tax free at retirement. Starting January 1, 2006, the Roth 401k salary deferral option became available in a Self Employed 401k. This plan known as a "Self Employed Roth 401k" combines features of Roth IRAs, but with higher contribution limits.
What are the differences between making pre-tax versus after-tax (Roth) contributions in my Self Employed 401k?
Self Employed 401k salary deferral contributions can be made as Roth 401k (after tax) or Traditional 401k (pre-tax).
The basic difference between a Roth 401k and a Traditional 401k is that the Roth 401k is funded with after-tax contributions while the Traditional 401k is funded with pre-tax contributions. In other words, with a Roth 401k you pay taxes today in return for a tax-free withdrawals in retirement. Traditional 401k contributions are tax deductible and are made pre-tax so you save taxes today, but withdrawals are taxed in retirement. As a result, the choice between the two 401k options comes down to whether you believe your income taxes rates will be higher or lower in retirement. If you believe your income tax rates will be higher at retirement then making Roth 401k contributions may be more advantageous. Also, there may be some estate tax benefits of a Roth 401k because in the case of death, the Roth 401k assets are tax free to your heirs.
How is the Self Employed Roth 401k different from a Roth IRA?
A Self Employed Roth 401k is similar to a Roth IRA because it allows after-tax contributions to grow tax-free until retirement when they are withdrawn tax free. However, a Self Employed Roth 401k allows much higher annual contribution amounts than a Roth IRA. In 2018 a Roth IRA has a $5,500 limit and $6,500 limit if age 50 or older. The 2018 contribution limit for the Self Employed Roth 401k is $18,500 and $24,500 if age 50 or older.
What are the advantages of the Self Employed Roth 401k over the Roth IRA?
- Regardless of income, everyone qualifies for a Self Employed Roth 401k. In 2018, you can’t fully contribute to a Roth IRA if your adjusted gross income exceeds $189,000 if you file a joint tax return with your spouse. If you are married filing jointly and your earned income is between $189,001 and $199,000, your 2018 Roth IRA contribution limit phases out. If you file as single or head of household in 2018, you can’t contribute fully to a Roth IRA if your adjusted gross income exceeds $120,000. If your earned income is somewhere between $120,001 and $135,000 then your 2018 Roth IRA contribution limit phases out.
- Higher contribution limits are permitted with a Self Employed Roth 401k than a Roth IRA. In 2018 participants can contribute up to $18,500 to a Roth 401k ($24,500 if age 50 or older), but they can only contribute $5,500 ($6,500 if age 50 or older) into a Roth IRA.
How much can I contribute to a Self Employed Roth 401k annually?
The 2018 Self Employed Roth 401k contribution limit is $18,500 and $24,500 if age 50 or older. The 2017 salary deferral limit is $18,000 and $24,000 if age 50 or older.
Can the profit sharing portion of a Self Employed 401k also be made with after-tax (Roth) contributions?
No. The profit sharing contribution can not be made as a Roth contribution.
A profit sharing contribution of up to 25% of compensation can also be made into a Self Employed 401k. The profit sharing portion of the Self Employed 401k contribution is not eligible to be made as a Roth contribution. Profit sharing contributions are made pre-tax and are tax deductible.
In 2018 the combined salary deferral and profit sharing contributions in a Self Employed 401k cannot exceed $55,000 and $61,000 if age 50 or older.
When can I withdraw from my designated Roth 401k account?
At age 59 ½, or later provided the 5 year rule is satisfied. An exception to the age 59 ½ rule occurs in the event of disability or death (in which case the proceeds are tax free to your heirs).
What is the “five-year rule”?
Assets may be withdrawn tax-free from a Self Employed Roth 401k provided the account has been established for five or more years and you are age 59 ½ or older. An exception is made in case of disability or death.
Who is best suited for a Self Employed Roth 401k?
The Self Employed Roth 401k is a new salary deferral option which is useful for a wide variety of people. See if any of the scenarios below apply to you.
1) You anticipate being in a higher income tax bracket in retirement than your current income tax bracket
If this is the case then it may make sense to make after tax Roth 401k contributions and pay income taxes now while in a lower tax bracket. Then while in retirement the assets can be withdrawn tax free when you are in a higher tax bracket.
2) You are relatively young and earn a lower income now, but expect to earn a much higher income and expect to be in a higher tax bracket in the future
If you expect your income to increase dramatically over your career, you may find contributing to the Roth feature today to be very advantageous, as you are in a lower tax bracket now than you will be in the future. Also, if you are many years from retirement, you could choose a Roth 401k as your best option as you expect your retirement plan to grow tax-free to a significant nest egg that can be withdrawn tax-free, more than compensating for the taxes paid when young and lower paid.
3) You had an usual year and your income decreased considerably and as a result you are in a lower tax bracket this year than your expected tax bracket in retirement.
You may want to take this opportunity to make Roth 401k contributions since you are in an usually low tax bracket this year.
4) Retirement investors who feel federal income tax rates will increase in the future
If you believe the government will increase tax rates in the future, then you may be better off making Roth 401k contributions and paying income taxes now. That way you would be paying taxes now at a lower tax rate and receiving the distributions federal tax free in the future at retirement when income tax rates are higher. Current income tax rates are low by historical standards.
5) You already have considerable assets in traditional pre-tax retirement accounts
In that case you may want to diversify your future tax liability and invest salary deferral contributions into the Roth 401k. That way some of your retirement nest egg can be withdrawn tax free at retirement. That is especially beneficial if tax rates rise in the future.
6) You earn a high income and would like to make Roth IRA contributions, but can’t based on the Roth IRA income limits
- Roth IRAs have income limits, but Self Employed Roth 401k plans have no income limits.
- Everyone qualifies for a Self Employed Roth 401k. In 2018 you can’t contribute fully to a Roth IRA if your adjusted gross income exceeds $189,000 if you file a joint tax return with your spouse and $120,000 if you file as single or head of household.
- Higher contribution limits are permitted with a Self Employed Roth 401k than a Roth IRA regardless of income.
- In 2018 participants can contribute up to $18,500 to a Roth 401k and $24,500 if age 50 or older. 2018 Roth IRA contribution limits are $5,500 and $6,500 if age 50 or older.
7) You wish to reduce future taxes on social security benefits
Qualified withdrawals from a Self Employed Roth 401k are excluded from taxable income when calculating taxes on Social Security benefits.
Currently half of Social Security benefits are taxable if AGI (adjusted gross income) plus one half of social security benefits exceeds $32,000 if married filing jointly or $25,000 if single. Note that the $32000 / $25000 threshold has never been adjusted since 1993. As a result, the value of tax savings via Roth accounts increases over time. Distributions from a Traditional 401k are included in AGI for determining Social Security benefit taxes, but distributions from a Self Employed Roth 401k are excluded, therefore saving taxes on Social Security benefits. Consult your tax advisor to verify your tax savings.
8) You want to avoid taking Required Mandatory Distributions (RMDs) at age 70 ½ and you like the idea of passing assets tax free to your heirs
You can roll over a Self Employed Roth 401k to a Roth IRA and avoid the legal requirement to take withdrawals at age 70½. This can save significant taxes and be useful for estate planning because the taxes saved will increase your estate and your heir's distributions will be tax free in the future as well.
However, remember the following important considerations:
- Roth contributions are irrevocable. Once the money goes into a Roth 401k account, it can't be switched over to a regular 401k.
- Also, Roth contributions are subject to federal state and payroll taxes in the year the Roth contribution is made (but are withdrawn tax free at retirement and grow tax free during working years).
- You can roll over Self Employed Roth 401k contributions to a Roth IRA when retired or if terminated.
- There is never a requirement to take a distribution from any Roth type retirement plan. This can help with tax planning to minimize taxes on Social Security benefits.