Because the traditional IRA had mostly non-deductible contributions, I will not pay much tax for this conversion. I plan to do the same contribute-then-convert move in 2011 and beyond unless Congress changes the law.

Having a solo 401k made things easy for me. This post is a sidebar about the history of solo 401k.

Solo 401k came about in 2002 after Congress passed Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). EGTRRA added this small paragraph to the tax code (26 USC 404(n)):

(n) Elective deferrals not taken into account for purposes of deduction limits

Elective deferrals (as defined in section 402(g)(3)) shall not be subject to any limitation contained in paragraph (3), (7), or (9) of subsection (a) or paragraph (1)(C) of subsection (h) and such elective deferrals shall not be taken into account in applying any such limitation to any other contributions.

That one small paragraph put forward the solo 401k as the preferred retirement plan for self-employed persons.

Before EGTRRA, a self-employed person was also able to set up a 401k plan just for him- or herself. However, there wasn’t a good reason to do so, because the deduction limit for a 401k plan was the same as that for a SEP-IRA. A SEP-IRA is easier to set up and administer than a 401k plan.

The small paragraph EGTRRA added basically says the employee contributions to a 401k plan does not count toward the deduction limit. As a result, a self-employed person can contribute more money to a solo 401k than to a SEP-IRA. Because business owners are usually interested in maximizing all available tax deductions for retirement, a solo 401k plan became preferred to a SEP-IRA.

EGTRRA also affected corporate 401k plans. Before EGTRRA, employers usually limited employee contributions to no more than 15% of compensation. Together with the company match, the total contributions would stay below the deduction limit, which is 25% of payroll. After EGTRRA, employee contributions no longer count toward the 25% limit. Many companies responded by increasing the employee contribution maximum to 50% of compensation or more. This has allowed lower-income employees to contribute the maximum dollar amount allowed under the law known as the 402(g)(3) elective deferrals limit, currently $16,500 per year.

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• Solo 401k For Part-Time Self-Employment
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It sounds like a 401(a) money purchase plan. The decision is one-time: if she doesn’t join now, she won’t be able to join later. If she joins, she must contribute 5% of her pay and the college puts in 8%.  But, she’s tight in her budget. You can imagine so after her husband’s pay was cut in half. So she asked the radio program if she should join the retirement plan.

Listen to Q&A online

What do you think? I don’t know how much colleges pay part-time instructors. Let’s say she earns $40,000 a year from this job. So we are talking about $2,000 a year.

It turns out she and her husband have substantial savings, both retirement and non-retirement, to the tune of $200k in each bucket. It makes the question such a no-brainer.

Money is fungible. If she uses her savings to make up for the reduced pay because of retirement plan contributions, she effectively moves the money from non-retirement savings into a retirement plan, eliminating taxes on the future growth of that money, and earning a 160% match to boot. What a deal!

What if she doesn’t have any non-retirement savings to make up for the shortfall in pay? Should she still join the retirement plan? What if she doesn’t have any savings at all, retirement or otherwise? Should she still join the plan? If she does join, where does the money come from? I will leave these questions to you. I trust you will be able to figure them out.

This will be the last post for the week. Happy Holidays!

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In preparation for converting my non-deductible IRA contributions to Roth IRA in 2010, I’m rolling over the pre-tax portion of my traditional IRA to my solo 401k. I set up the solo 401k last year primarily for this purpose — to provide a harbor for my pre-tax IRA money so I won’t get taxed proportionally on my Roth conversion. After the rollover, I should have only one small IRA, consisting of my non-deductible contributions plus or minus market fluctuations from now until I convert in January 2010.

I have my solo 401k with Fidelity. When I called them about the rollover procedures, to my surprise, the rep actually discouraged me from doing so. To his credit, he made valid points. He knew what he was talking about. Fidelity trained them well.

He said the 401k has more restrictive rules on withdrawals. Before I reach 59-1/2, I can withdraw from a traditional IRA for any reason. I just have to pay tax and the 10% early withdrawal penalty. Not that people should do that but that option is there. If I put the money into the solo 401k, I have to qualify for specific hardship events before I’m allowed to withdraw and pay the tax and the 10% penalty. Fidelity’s solo 401k plan does not allow loans.

He also said rolling over money in an IRA to a solo 401k will get the solo 401k closer to an IRS reporting threshold. When a solo 401k plan’s assets reach $250,000, the plan administrator will have to file a Form 5500-EZ with the IRS every year. I can avoid the extra paperwork for more years if I don’t rollover IRA money into my solo 401k.

I would agree with him if I’m not preparing for the Roth conversion. I decided the benefits of low taxes on Roth conversion outweigh the restrictions on withdrawals and the extra paperwork.

The actual rollover consists of two steps. Because I’d like to keep the assets in my IRA, I would transfer in-kind to a new Fidelity Rollover IRA as a bridge. After that’s done, Fidelity needs a letter from me as the administrator of my solo 401k to accept the rollover from my Fidelity Rollover IRA. Then the bridge rollover IRA will be closed. Fidelity will not charge the usual $50 IRA closing fee.

I initiated the partial rollover online with Fidelity last Wednesday. I mailed the transfer of assets form on Thursday. By Tuesday, the rollover is completed. Four business days. Fidelity did a very good job.

With the rollover, I said goodbye to Vanguard Brokerage Service. Vanguard is a great mutual fund company, but its brokerage service is substandard. In order to avoid complications with the rollover, I wanted to change my dividend reinvestment election from automatically reinvest to taking the dividend in cash. I got this nice message when I tried to do so:

Vanguard Brokerage Service is saying their computers for processing dividend reinvestment elections go off their shift at 5 p.m. Eastern time. I honestly cannot think of any reason why computers work only a day shift.

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1. Sample language for 401k plan auto-enrollment. The IRS gave employers some sample language for adding auto-enrollment to their 401k or SIMPLE IRA plans. The IRS also made it clear it’s legal to automatically increase the employees’ contribution percentages.

Half of the workforce does not have a retirement savings plan at work. Auto-enrollment can’t help if you don’t have a plan to begin with. For the other half, the employers will still have to take the trouble to add auto-enrollment. After that, auto-enrollment usually only covers new employees. Employers very rarely re-auto-enroll existing employees if they are not already enrolled. So we are only talking about a low single digit percent of the workforce here.

Changing somebody’s paycheck is always tricky. According to a recent study by Vanguard, only 20% of the plans have auto-enrollment at the end of 2008. Of the plans that have auto-enrollment, the typical default contribution percentage is 3% of pay. 3% is better than 0%, but it is still far too low.

2. Buy I Bonds with tax refunds. The IRS will add a checkbox to the tax form and upsell taxpayers on purchasing I Bonds with their tax refunds, in the same way airlines sell seat upgrades and travel insurance.

If the taxpayer wanted I Bonds for their tax refund, they can always buy the bonds themselves after they get the refund. The checkbox on the tax return just makes it a little easier. However, the I Bonds bought with tax refund are still subject to the same $5,000 per year per person paper bond purchase limit. They still can’t be sold until after 12 months. Some people are due for a surprise.

3. Contribute unused vacation to 401k plan. When you leave your job and you have unused PTO hours, you can turn them into 401k contributions instead of getting paid in cash.

Once again, you have to have a 401k plan to begin with. Then your employer will have to amend the plan and allow it. Finally, the contributions from unused PTO hours still count toward your annual contribution limit unless the employer eliminates the cash-out option and automatically shoves the unused PTO hours to the 401k plan. I can’t see many employers will choose to do that.

This might help some people who won’t have a 401k plan in their next job and don’t need the money when they leave their current job. Again, we are talking about a small percentage of people here.

4. New Special Tax Notice about rollovers. The IRS published two new model tax notices for 401k plan distributions when people leave their jobs.

The new notices make rollover sound like the default option and downplay the cash-out option. I don’t know if people actually read the notice in their paperwork. It’s all nice and well if people read it. I’d also like to know if people who cash out their 401k plan now didn’t know about the rollover option or they knew it and still chose to cash out. If it’s the latter, the new tax notices won’t do any good.

I would much like to see our government stop dancing on the edges and put forward some real reform. I realize the real reform has come from the legislature. Maybe President Obama can push for it after he’s done with health care.

How about unleashing that "public option" called the TSP? Let companies who don’t have their own plan subscribe to the TSP. That will cover half of the workforce in one fell swoop. Let employees choose between the employer’s plan and the TSP. Give some real competition to the high cost plans.

How about liberating the market-based solutions called the IRA? Increase the IRA contribution limit and let people choose between the IRA and their 401k plan. Allow rollovers to an IRA at any time.

What about the company match? If the employer makes the match immediately vested, the match can follow to the TSP or the IRA. If the employer wants to impose a vesting schedule, the match can stay in the employer plan. It’s not that hard.

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401(k) plans are offered primarily by private sector employers. Employees in public schools and tax-exempt organizations have 403(b) plans. State and local governments and tax-exempt organizations have 457 plans. Some employers offer both a 403(b) plan and a 457 plan. What is a 401(a) plan then?

Strictly speaking a 401(a) plan is a bit of a misnomer because other kinds of plans including 401(k) plans must also qualify under tax code 401(a). In a loose context, a 401(a) plan is a retirement savings plan in which employees can’t choose or change the amount contributed to the plan. It’s also called a “money purchase plan.”

In a 401(k) plan, employees make so-called “elective deferrals” which means that employees have a choice between (a) contribute to the plan and defer income tax on the contributions; and (b) receive the money in cash and pay the tax. In a 401(a) money purchase plan, either the employer contributes to the plan all by itself OR the employer makes it mandatory for all covered employees and deducts a set percentage from everybody’s paycheck.

As a result, contributions to a 401(a) plan do not count toward the 401(k) “elective deferrals” limit ($16,500 in 2009). If someone has a both 401(a) plan and a 401(k) plan, he or she can still contribute up to $16,500 in 2009 to the 401(k) plan. Contributions to a 403(b) plan or a SIMPLE IRA also count toward the same 401(k) elective deferral limit, but contributions to a 457 plan do not (go figure).

I don’t work in the employee benefits field any more. It still amazes me how many different types of retirement plans we have in the tax code and how they have similar but different rules. We’ve got this alphanumeric soup:

• 401(a) money purchase  plan
• 401(k) plan (with Traditional and Roth accounts)
• 403(b) plan (with Traditional and Roth accounts)
• 457 plan (no Roth yet, why?)
• SEP (no employee contributions allowed, why?)
• SIMPLE 401(k) (lower contribution limit than regular 401k, why?)
• SIMPLE IRA (no Roth, why?)

Why can’t we just have one type of plan regardless where you work? The more you look at anything related to the tax code, the more you see it’s a total mess.

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Good ideas:

1. Auto-enroll all employees. Default contribution % and investment. Average participation rate among eligible employees in companies with a defined contribution plan is about 70%. That’s too low. Auto enrollment and default contribution and investment choices make it easier for everybody to participate in the plan. If the employees did nothing, they will be in the plan, have a reasonable contribution percentage and a reasonably diversified investment.

2. Limit cashout when an employee changes jobs. Too many employees just take a cash withdrawal when they change jobs. This proposal makes sure retirement savings stay in plans intended for retirement savings.

3. Default distribution to an annuity. Make sure the money will last a lifetime. As long as there are opt-outs and the plan is required to shop for the best rate on annuities, I think it’s a good idea to have an income stream you will never outlive.

4. Automatically bump contribution % with pay increase. Help people save more tomorrow. Great idea.

5. Create a state pool for small employers. Small employers on average either don’t have a plan or have really bad plans. It’s really not necessary to have every small employer create their own plan. They can just join a state pool. Leveraging economy of scale is good.

6. Disassociate 401k with employers. This goes one step beyond state pools. Let everyone join a national plan like the Thrift Savings Plan (TSP) for federal government employees. Employers can match into it. Say goodbye to bad plans set up by employers. I like that!

Bad ideas:

1. Expand Saver’s Credit. This proposal gives a tax credit to people who earn up to $70,000. Right now people don’t participate because they can’t take the reduction in pay, not because the tax break is too small. Giving them a small tax credit won’t help much.

2. Automatic IRA. This proposal will have employers who don’t have a retirement plan send payroll deductions to an IRA for their employees. People who want an IRA can do it themselves through direct deposit already. I don’t see how this achieves anything.

3. Replace 401k with a government guaranteed pension. Too much a lure for diverting the money elsewhere. We already have Social Security for a government guaranteed pension. Look at how Social Security money is used. People should have some money for themselves.

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When I tried to figure out how much I can contribute from my self-employment income to the solo 401k, I found that the information on the Internet assumes that the self-employment income is the person’s only earned income. For example the calculation worksheets provided by Fidelity, Schwab, and Vanguard all make that assumption. They don’t consider the cases like me who work at a day job while earning some self-employment income on the side. Because I participate in the 401k plan at work, the maximum I can contribute to my solo 401k plan changes with what I earn from my day job and what I contribute to the workplace 401k plan. The Social Security tax I pay depends on the sum of my salary as an employee and my self-employment income. The salary deferral contributions I can make from self-employment income also depends on how much I already contribute to my 401k plan at my day job. I would think there are enough consultants, freelancers, moonlighters, and bloggers who are in the same camp as I am, but there is very little resource I could find for people who earn their income from a mix of W-2 salary and self-employment.

You know where this is going to lead to, don’t you? I had to create a spreadsheet for myself and I’m sharing it here in case other people like me find it helpful.

Spreadsheet: Solo 401k For Part-Time Self-Employment

This spreadsheet takes into account employment income, contributions to workplace 401k, and self-employment income. It calculates the maximum salary deferral contribution and the maximum profit sharing contribution I can make to my solo 401k plan. If there is no day job, just set the day job related fields to zero and it will work for people who only have self-employment income as well. There are two tabs: one for an unincorporated business (sole proprietorship), the other for an incorporated business. As usual, use this and everything you find on this blog at your own risk, because I’m not a CPA.

I’m going to use Fidelity for my plan because I already have other accounts with them and their plan is free and flexible. Vanguard is going to offer a plan but it looks like they don’t allow incoming rollovers and there is no brokerage option.

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“Also, never ever borrow against your 401k plan because you will pay double taxation on the money you borrow. Because you don’t pay taxes on the money you put into a 401k, when you pay back the loan (which you must do within five years, or 15 years if used to buy a home), you pay it back with money you have paid taxes on. Then, when you retire and take the money out again, you end up paying taxes on it a second time.”

This allegation is all over the place — MSN, USA Today, The Motley Fool, Moolanomy blog. It is a myth because there is NO double taxation. It’s a mind trick similar to that well-known “where’s the missing dollar” puzzle.

“Three men went into a hotel. The manager said the room was $30 so each man paid $10. A while later the manager realized the room was only $25 so he sent the bellboy to the 3 guys’ room with $5. The bellboy only gave each man $1 back and kept the other $2 for himself. Now 3 men paid $9 each for the room, which is $27. Add the $2 that the bellboy kept, and that’s $29. But the 3 men paid $30 originally. Where is the other dollar?”

I was able to find a good explanation for this puzzle. The $30 number is irrelevant. The correct math is $27 – $2 = $25. It makes no sense to add $2 to the $27 because it’s already a part of the $27. The $2 should be subtracted from the $27.

Now, back to our 401k double taxation myth. The fact that the loan has to be repaid with after-tax dollars is irrelevant, just like the $30 number in the hotel puzzle. If you didn’t borrow from the 401k plan but you borrowed from a bank, you’d have to pay the bank back with after-tax dollars as well. If you didn’t borrow from your 401k plan but you dipped into your own savings, you have to replace those savings with after-tax dollars too. What it really means is that a 401k loan is not tax deductible, just like any other consumer loan except a mortgage or a HELOC. Instead of saying you will be double taxed, they should just say that a 401k loan is not tax deductible, plain and simple.

I have this post in draft for a long time but Jonathan at My Money Blog beat me to it recently with two posts trying to debunk this myth (post 1, post 2). After so much discussion some folks are still not convinced. I think this issue is best illustrated by this chart below:

The left hand side represents a typical consumer loan, like a car loan. The arrows represent “borrows from” and “pays back to.” You borrow from a bank. The bank borrows from the financial market. Your 401k invests in the financial market. I think we all agree there is no double taxation in this case. You pay after-tax dollars to the bank for both principal and interest. Your 401k earns from the financial market but the earnings have to be taxed when you withdraw from your 401k.

The right hand side represents a 401k loan. Now, if you put an imaginary box in the middle on the right hand side, it becomes exactly the same as the left hand side. You borrow from an imaginary middleman and pay after-tax dollars for both principal and interest. This imaginary middleman then borrows from your 401k and passes the same dollars it receives from you to your 401k. All of a sudden you are not double taxed any more because it looks exactly the same as a car loan on the left hand side. Because this middleman is only imaginary, it follows that you are not double taxed with a 401k loan, whether for the principal repayments or for the interest.

Whether or not you are mathematically better off with a 401k loan depends on how these three rates play out:

• your alternative after-tax interest rate from a bank loan
• what bond funds in your 401k are expected to earn from the market
• the interest rate on your 401k loan

Suppose your alternative after-tax interest rate from a bank loan is 7% and the interest rate on your 401k loan is 5%. If you borrow from your 401k, you save 2% in interest cost in after tax dollars. But also suppose the bond funds in your 401k are expected to earn 8%. If you borrow from it, your 401k plan can only earn 5% from you. So your 401k plan account is 3% worse off in before-tax dollars. Between 2% better off after tax and 3% worse off before tax, it can become a wash. The reason you have to compare it with what bond funds can earn is because the 401k loan payments are not subject to market fluctuation. If you do borrow from your 401k, increase your allocation to stocks for what’s left in the plan.

While there is no double taxation on a 401k loan, there are other negatives on borrowing from your 401k plan. The biggest negative is that if you change jobs (voluntarily or involuntarily), you often have to repay the outstanding balance of the loan within a short period of time, like 60 days. Some plans actually allow you to continue the loan repayment even after you terminate employment, but not all plans do that. If you really need cash and you don’t have any other source except your 401k, taking out a 401k loan is at least better than taking a hardship withdrawal from the plan. Just be absolutely sure you will be able to repay the loan and you won’t change jobs before paying off the loan. And don’t reduce your regular 401k contributions while you are paying off the loan.

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If the plan has a match, you contribute enough to get the full match. That’s a no-brainer, because the match will more than compensate for the high costs and hidden fees. But then what? Any additional money you contribute to the plan won’t get any more match. Or perhaps the plan doesn’t have a match to begin with or your employer contributes to the plan regardless whether you contribute or not.

In these cases, should you still contribute to the high cost 401k or 403b plan even when there is no [additional] match? I made a spreadsheet to compare the alternatives.

1. Roth IRA. If you are eligible, contributing to a Roth IRA is a good alternative to a no-match 401k or 403b. Because a Roth IRA is under your own control, you can buy low cost funds in your Roth IRA. The lower your costs, the more investment returns you get to keep.

2. Non-Deductible IRA. If you are not eligible for contributing to a Roth IRA, you are still eligible to contribute to a non-deductible Traditional IRA. The contributions are not tax deductible but the investments grow tax deferred inside the IRA.

Under the current law, there is an opportunity to convert a non-deductible Traditional IRA to a Roth IRA in 2010 and thereafter. This 2010 Roth conversion issue is beyond the scope for this post. See Should I Contribute To A Non-Deductible IRA? Part 1, Part 2 on My Money Blog for more information. For the purpose of this post, I assume the non-deductible IRA is going to stay as-is and not converted to Roth.

3. Taxable Account. Another alternative to a high cost 401k or 403b plan is investing in a regular taxable account.

If you buy tax efficient stock funds, the majority of your returns will come as unrealized capital gains which are not taxed until you sell. When you do sell, under the current laws, the long-term capital gains are taxed at a more favorable rate than ordinary income.

4. Contribute to the plan and then rollover. The alternatives are not necessarily better than contributing additional money to the 401k or 403b plan even if the cost is high and there is no match. This is true especially if you are not going to work for this employer for very long.

When you leave your employer, you can rollover the balance in your 401k or 403b plan to your own IRA. Then you will be able to use low cost funds. You just have to hold your nose and pay the high cost until you are liberated from the plan. A key input is how many years you will have to pay the high cost.

Finally, here is the spreadsheet that compares these options:

alternatives to high cost 401k or 403b plan

You will need the estimated tax rates, investment return, extra cost in the plan, how many years you will be in the plan and how many years you have until withdrawal. It then calculates “advantage over 401k” for each alternative. If the result is positive, it means that’s a better option. If it’s negative, it means it’s still better to contribute to the high cost 401k or 403b plan and wait for the rollover.

In many cases you will find that Roth IRA is better than a high cost 401k or 403b but the other two options are not. For example, under this set of assumptions,

we get

In this example, a Roth IRA is 7.2% better than a high cost 401k or 403b plan; a non-deductible IRA is 16.9% worse; and a taxable account is 19.9% worse. That’s why you often hear about the rule of thumb: 401k for the match, then Roth IRA, then back to 401k.

If you are not eligible for Roth IRA, the spreadsheet also indirectly compares a non-deductible Traditional IRA with a taxable account. In our example if you max out the 401k and you still have money to invest for retirement, you should do the non-deductible IRA before you invest in a taxable account because a non-deductible IRA is not as bad as the taxable account.

Feel free to plug in numbers applicable to yourself and see how the alternatives play out for you.

Notes:

1) Front-end load is often waived for 401k and 403b plans. Please verify with plan administrator.

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1. Find in your plan’s menu one fund that you are not using.
2. Do a one-time transfer and move $100 to it. Do not include this fund in your periodic payroll contributions.
3. Wait until a full quarter passes. On your next quarterly statement you should have the beginning and ending balance for that fund.
4. Calculate your gain/loss in that fund. Compare your actual gain/loss with the fund’s reported performance in the quarterly statement.

I did this test in my own plan. Before the end of the first quarter, I transferred a small amount to a fund I wasn’t using. During the second quarter, I did not add any more money to the fund. The money sat in the fund untouched for the entire quarter. Now I’m able to calculate my gain or loss and compare it with the performance reported by the fund.

According to my online account information, I had $99.77 in the test fund as of March 31, 2008 and $97.04 as of June 30, 2008. My gain/loss in the 2nd quarter was 97.04 / 99.77 – 1 = -2.74% in that fund. According to the mutual fund’s web site, the fund’s performance in the 2nd quarter was also -2.74%. My loss in the fund wasn’t any larger than what the fund reported. That means there were no hidden fees deducted from my account during the quarter. Yay!!!

Did you also do this experiment? Do you know if there are hidden fees in your plan?

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