Using an Individual Roth 401(k) as a Self-Employed Tax Shelter
A great way for small business owners to save money on taxes.
The Economic Growth and Tax Relief Reconciliation Act of 2001 authorized the creation of a new type of 401(k) plan called the Roth 401(k). As you may have guessed, 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 gains, dividends, or interest.
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.
Who Should Use This Plan?
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 year due to the way the contribution limits and matching are calculated.
An Example of How a Roth 401(k) Plan Works
To demonstrate how extreme this can be for super-savers and aggressive investors: a successful married couple in 2021 could put up to $39,000 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 the household income distribution. They set up their new retirement system and fund it, earning an average of 7% every year for 35 years, never missing an Individual Roth 401(k) contribution. By the time they turned 65, they'd be sitting on more than $5.8 million in tax-free wealth.
The 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 things 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.
- An Individual Roth 401(k), unlike a Roth IRA, requires mandatory distributions once you reach age 72. 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.
- Not all brokerage houses offer Individual Roth 401(k) products.
- 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.
Regardless, 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.
Congressional Research Service. "Saving for Retirement: Household Decisionmaking and Policy Options," Pages 3-4. Accessed Jan. 9, 2021.
Internal Revenue Service. "One-Participant 401(k) Plans." Accessed Jan. 9, 2021.
Internal Revenue Service. "Retirement Plan and IRA Required Minimum Distributions FAQs." Accessed Jan. 8, 2021.
Internal Revenue Service. "Rollover Chart." Accessed Jan. 9, 2021.