The Origin of Solo 401k

As I wrote in a previous post Rollover IRA to Solo 401k, I rolled over substantially all pre-tax money in my traditional IRA to my solo 401k plan in 2009. My traditional IRA was left with non-deductible contributions plus a little bit of earnings. For 2010, I made another non-deductible contribution before I converted the whole thing to a Roth IRA.

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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Comments

  1. dns says

    TFB
    I read about the solo 401 on this blog and your comments on the bogleheads forum. What a GREAT idea! I did exactly what you outlined, and converted the remaining dollars (essentially all non deductible) into a Roth. I will also use the solo 401 to receive in service withdrawals from a high cost 40, reducing my investment expense. Thanks

  2. Harry Sit says

    enonymous – I think it’s better if you create some self-employment income. There are so many personal service things anybody can do: wash cars, mow lawns, walk dogs, house sitting, tutor kids, …

  3. Joel says

    Keep in ind that if their is need for permanent life insurance the one person 401k
    can utilize tax deductible life insurance in the plan. Thus making the plan self completing in case of death.

  4. KD says

    I was wondering this: Lets say, I have a full time employment with a 401k plan with poor choices and no match. I have some self-employment income which is no where close to full time employment income. Then can I open a solo 401k and contribute till maximum $16500 to the funds or stocks of my choice?

  5. roy says

    TFB
    I am having a hard time understanding how you are achieving any benefit.

    Lets say you have 40K in a money market non-deductible traditional IRA. And you have 100K in a rollover IRA (the rollover was from a 401k). If I do nothing and put all this money into Roth, I pay taxes on the 100k.

    What you are doing (I think) is converting the 40K into a solo 401(k) and then transfer that to Roth IRA. You will end up paying taxes on that 100k.

    I guess I am wrong somewhere but where?

  6. Harry Sit says

    Roy – You convert the 100k into a solo 401(k) and then convert the 40k to Roth IRA. That way there is no/minimal tax due on the Roth conversion.

  7. howard says

    I’m going to open an individual 401K account this year. I have bonds in a taxable account I’d like to contribute rather than funding the account with cash. Can I do that?

  8. Harry Sit says

    howard – No, your contributions must be in cash. Unless you are talking about individual bonds that will cost you a lot to sell, you can sell from your taxable account, contribute, then buy in your solo 401k.

  9. gary says

    Doesn’t the conversion of the 401K, funded with rolled pre tax IRA funds incur a taxable event at the time you convert the 401K to a ROTH 401K?

    • Harry Sit says

      Gary – Yes but you don’t have to convert a traditional 401k to a Roth 401k. Just leave it as traditional 401k.

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