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 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.
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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 they will never have to pay taxes again on any of the capital gainsdividends, 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," more commonly known as an "individual Roth 401(k)," can be one of the most extraordinary wealth-building tools in the arsenal.

Key Takeaways

  • An Individual Roth 401(k) plan is like a Roth 401(k) plan, except it is opened by a self-employed person with no employees.
  • In 2021, a married couple can put up to $39,000 into Individual Roth 401(k) accounts and would not have to pay taxes on withdrawals in retirement.
  • There are some drawbacks to Individual Roth 401(k) accounts, including mandatory distributions at age 72.

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 Type of Plan?

This type of plan 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 "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 tool 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 could 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:

  • 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 rule. 
  • 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.

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.