Use the Individual Roth 401(k) as a Self-Employed Tax Shelter

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Individual Roth 401(k) Plan
The new individual Roth 401(k) plan combines the best features of a Roth IRA and a traditional 401(k). Self-employed people can often use it to save huge amounts for retirement while avoiding taxes on the capital gains, dividends, interest, rents, and other profits. Creativeye99 / E+ / Getty Images

Almost a decade ago, Congress authorized the creation of a new type of 401(k) plan called the Roth 401(k).  This was designed to create a 401(k) equivalent of the Roth IRA, to which the investor contributes after-tax funds (no tax deduction), but, in exchange, will never have to pay taxes again on any of the capital gainsdividends, interest, or future withdrawals from the account provided the rules are followed and there are no statutory adjustments in the meantime.

While it might sound boring, this distinction means that the Roth 401(k) is, for all intents and purposes, one of the single best tax shelters ever devised in the history of the United States.  Nothing comes close to allowing you to put away so much money, compound it for decades, and then live off the passive income without ever sending anything to the Federal or State governments again.  For self-employed individuals and their spouses who operate without any employees, setting up a so-called "One-Participant Roth 401(k) Plan", or more commonly known as an Individual Roth 401(k), can be one of the most extraordinary wealth building tools in the arsenal.

What Is an Individual Roth 401(k) Plan?

For all intents and purposes, an individual Roth 401(k) plan is identical to a Roth 401(k) plan established by a business except that the self-employed person has no employees.  This makes it possible to avoid hassles like so-called "discrimination testing", which involves calculating formulas to make sure you aren't favoring higher paid executives; a moot point considering you, and possibly your spouse, are the only people involved.

It is ideally suited for self-employed men and women who either own a small business with no employees, do a lot of freelance work, generate income from consulting, or otherwise engage in activity that results in earned income.  Unlike its nearest competitor, the SEP-IRA, the sometimes dubbed "Self-Employed 401(k)" makes it possible to put aside quite a bit more money every twelve months due to the way the contribution limits and matching are calculated.

To demonstrate how extreme this can be for super-savers and aggressive investors: Under the right conditions, a successful married couple in 2015 could put up to $106,000 between the two of them into these tax shelters.  For the sake of perspective, picture an affluent husband and wife, 30 years old, who are in the top of household income distribution.  They setup their new retirement system and fund it, earning a good rate of return on their investments every year for 35 years, never missing an Individual Roth 401(k) contribution.  Completely ignoring the probable future increases in the contribution limits as well as so-called "catch-up" contributions that allow those 50 years or older to deposit even more money each year, by the time they turned 65, they'd be sitting on $28,728,583 in tax-free wealth.  With an assumed 3% dividend yield, they'd be collecting around $861,857 in cash dividends per year.  They could withdrawal that money and, under the present rules, their tax rate would be nothing.  Zero.  We're talking about $71,821+ per month in cold, liquid, cash income and none of it going to the Treasury Department.  If they wanted, they could raid the entire account and spend all of the principal, too.

 (Of course, you'd need to make an inflation adjustment to estimate purchasing power equivalent thirty-five years hence but it's still a lot of cash arriving like clockwork.)

This wealth-building-on-steroids feature of the individual Roth 401(k) has worried some members of Congress and even President Obama, who wanted to put limits on the account balance you can maintain within your Roth IRA or other retirement accounts, perhaps capping it at $3,000,000.  The political will hasn't been there to do it, yet, but that could change so it's a risk you'd need to consider.  Nevertheless, you'd still likely be better off than you otherwise would have been had you not used the individual Roth 401(k) as a legal structure through which you held your blue chip stocks.  The proverbial cake is still going to be sweet, it's just a matter of how sweet.

There Are a Few Minor Drawbacks for the Self-Employed Who Want to Set Up an Individual Roth 401(k)

While often the best choice if you qualify, there are a few thing that make an individual Roth 401(k) slightly less than perfect.  These include:

  • Establishing an individual Roth 401(k) plan can be a lot of initial paperwork.  It's worth it.
  • An individual Roth 401(k), unlike a Roth IRA, requires mandatory distributions once you reach age 70.5 years old.  However, you might be able to roll over your individual Roth 401(k) assets to your Roth IRA once you're no longer employed, effectively getting around this.  You absolutely should not attempt such a strategy without consulting with a qualified tax expert who should be able to confirm in writing whether or not it can be done in your situation.
  • The Roth tax benefits were going to expire in 2010 but Congress decided to extend it in the Pension Protection Act of 2006.  It's theoretically possible the program could end some day but that shouldn't take away many of the advantages you enjoy in the present as an individual Roth 401(k) is still better than a regular, plain-vanilla brokerage account.
  • Not all brokerage houses offer Individual Roth 401(k) products, as incredible as that sounds in this day and age.  At the moment, E-Trade and Vanguard do but Charles Schwab, one of the largest brokerage houses in the world, doesn't!  When I spoke to a customer service representative on the matter, they couldn't provide any guidance as to why management had neglected to offer such an incredible tax shelter when many competitors did, nor confirm they had any intention of doing so in the future.  Again, this isn't a serious concern other than potentially diversifying your assets among different financial institutions.
  • You can't change your mind about Roth 401(k) contributions, rolling them over to your traditional 401(k) and taking the tax deduction, later.  Once it's done it's done.  It's a better deal in the long-run, anyway, so I recommend accepting it without too much complaint.  This is not a tragedy.
  • Under most conditions, individual Roth 401(k) plans with more than $250,000 in assets require an annual IRS filing on Form 5500-SF.  You get the form from the Department of Labor and, at present, it's only three pages.  Yes, it's a pain but isn't a little bit more work each year worth keeping thousands, or even millions, of dollars of your family's net worth out of the hands of politicians, who will spend it?

Regardless, I'd argue that anyone who can take advantage of these tax shelters probably should.  At the very minimum, it warrants a meeting with your qualified tax adviser to seriously discuss the topic.  The consequences in terms of real-world dollars and cents are profound.