Contributing to Both a Roth IRA and a Roth 401k Such as Roth Solo 401k for the Self-Employed with No Full-Time W-2 Employees
Individuals often prefer making contributions to Roth IRA and Roth 401k including Roth solo 401k because tax rates are bound to rise in the future.
Why Roth Funds?
For one, even though the tax payer does not received a deduction for making Roth contributions whether to the Roth IRA or the Roth 401k including the Roth solo 401k, the contributions grow tax free and in the case of a Roth IRA, the contributions can be distributed at anytime tax free.
Who can Make Roth Contributions?
In order to make Roth IRA contributions, the tax payer must have earned income under a certain level. Earned income includes the following:
- wages, salaries, tips and bonuses;
- self-employment income (earned income);
- Royalties;
- Commissions; and
- Taxable non-tuition fellowship and stipend payments, and difficulty-of-care payments for foster care workers (These are new under the SECURE Act.)
The income limit known as the modified adjusted gross income (MAGI) for making Roth IRA contributions adjusts each year (visit here for the limits), but for 2021 if you are married and file a joint tax return you can make a full Roth IRA contribution if your AGI is $196,000 or less. Those who are single with an AGI of $124,000 can make a full Roth IRA contribution.
For making Roth Solo 401k contributions, income limits do not apply like they do for making Roth IRA contributions (see above). To make Roth solo 401k contributions, they must be based on your net self-employment income from your self-employed business.
What are the Roth Contribution Limits?
For a Roth IRA, the tax payer can contribute up to $6,000, or $7,000 if age 50 or older for 2021 or 2022.
For a Roth 401k including a Roth Solo 401k, the employee can contribute up to $19,500, or $26,000 if age 50 or older in 2021 ($20,500 or $27,000 if age 40 or older in 2022).
Contribute to both a Roth IRA and Roth 401k Including a Roth Solo 401k
If the tax payer has the earned income to support the contributions, she can contribute to both a Roth IRA and a Roth solo 401k, as there is no combined limit for Roth solo 401ks and Roth IRAs. Therefore, you can max out both your Roth IRA contribution and Roth solo 401k contribution each year.
illustration
Jane is 53 years of age, single and ready to mingle, is self-employed and has earned income from self-employment income of $110,000 for 2021. She plans to make both Roth IRA and Roth solo 401k contributions. She can thus contribute the following amounts to both her Roth IRA and the Roth Solo 401k:
Roth IRA Contribution = $7,000
Roth Solo 401k Contribution = $26,000 ($19,500 plus $6,500)
By contributing to both her Roth IRA and her Roth solo 401k, Jane has made $33,000 in Roth contributions for 2021.
Roth IRA vs Roth 401k Distributions
For a Roth IRA, the basis (contributions) and earning can be distributed at anytime without meeting a triggering event. However, the earnings on the Roth IRA are taxable if distributed prior to both having a Roth IRA and if you are under age 59 1/2 at time of the distribution. The good thing about the Roth IRA, however, is that just contributions can be distributed both tax and penalty free at anytime without meeting a triggering event.
For a Roth 401k including a Roth solo 401k, yo can’t jus distribute the basis and must meet a triggering event to even take a distribution. A triggering even is the attainment of age 59 1/2, death or disability. Note: a first-time home purchase does not qualify as triggering even for making Roth solo 401k distributions but does for making Roth IRA distributions.
Qualified ROTH Distribution Vs. Non-Qualified ROTH Distribution
Qualified: A “qualified” ROTH distribution whether from a Roth IRA or a Roth 401k including a Roth Solo 401k will be both not be subject to taxes or penalties.
Non-Qualified: On the other hand, a “non-qualified” distribution from Roth IRA is only subject to taxes on the earnings not the basis.
The “non-qualified” distribution rules from a Roth 401k including a Roth Solo 401k are not as favorable. When a Roth solo 401k distribution is non-qualified, a portion of the distribution is taxable because the pro-rata rule applies. The pro-rate rule calls for part of the Roth solo 401k distribution to come out of the basis and part out of the gains. The taxable portion is the amount of the distribution multiplied by the taxable fraction (i.e., the amount of earnings in the Roth Solo 401k) divided by the total Roth solo 401k account balance.
illustration
Teresa is 62 and first contributed to her Roth solo 401k in 2018. The current balance in her Roth solo 401k is $100,000, consisting of $60,000 of contributions and $40,000 of earnings. She then takes a $64,000 distribution from her Roth solo 401k. Because she has not had the Roth solo 401k for 5 years, the distribution is deemed “non-qualified.” As a result, $25,600 [$64,000 x ($40,000/$60,000)] of her $64,000 distribution is subject to taxes, but not the 10% early distribution penalty since she is over age 59 1/2.
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