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.