The Roth-only 401k is a retirement savings plan available to self-employed individuals and sole proprietorships that combines the 401k alone with the Roth approach to taxation. It allows for higher contribution limits and tax-free earnings, making it an attractive retirement planning choice. The Economic Growth and Tax Relief The Reconciliation Act of 2001 dramatically increased contribution limits, and the Roth tax principles were extended to 401k plans in 2006. The IRS allows for a wide variety of investment options, and the Roth solo 401k is beneficial for self-employed individuals with volatile finances.
A Roth-only 401k is a retirement savings plan that is granted preferential tax treatment by the US Tax Code and is available to self-employed individuals and sole proprietorships. It’s actually two different concepts combined: the 401k alone and the Roth approach to superannuation taxation. The 401k alone allows self-employed individuals to establish 401k plans with themselves as the only participant, with contribution limits much higher than those available to participants in traditional employer-sponsored 401k plans and a wide variety of choices for investment of funds.
The Roth tax approach requires contributions to be made with after-tax dollars, as opposed to traditional 401k and IRA plans, where contributions are made with untaxed money. Under the Roth approach, however, all account earnings are generally tax-free, so that when a Roth plan is used to fund a taxpayer’s retirement, there is no income tax liability on the funds when they are withdrawn; when traditional IRAs and 401k’s are paid in retirement, the full amount is taxed.
The 401k only has been available to self-employed and sole proprietorships since 1978, when the Internal Revenue Code was amended to establish the 401k, an employer-sponsored plan for deferring pay and any accumulated earnings. The costs and difficulties of administration, however, together with the relatively low contribution limits, made the 401k a poor choice for the self-employed until 2002. New legislation that went into effect that year, the Economic Growth and Tax Relief The Reconciliation Act of 2001 (EGTRRA), dramatically increased contribution limits, allowing self-employed individuals to contribute approximately 40% of their earnings annually to a single 401k, suddenly making it a very attractive retirement planning choice.
However, Roth 401k-only accounts were still fully taxable when pulled out. The only Roth accounts that existed at the time were the Roth IRAs that had been introduced in 1997. Those accounts had low annual contribution limits — under $5,000 (USD) a year — and earnings thresholds. Taxpayers earning more than $120,000 (USD) were not allowed to create Roth accounts.
The EGTRRA extended the Roth tax principles to 401k plans, but delayed implementation until 2006. This, along with higher limits on the 401k alone, provided the self-employed with a tax-qualified retirement savings plan that would allow them to save relatively large amounts for retirement in a relatively short period of time. The IRS allows Roth 401k-only funds to be invested in a wide variety of asset classes, including debt-free real estate, life insurance policies, and annuities, as well as more traditional options like stocks, bonds, and mutual funds . Participants setting up a Roth-only 401k must identify a custodian for their accounts; if they have special preferences regarding investing funds, they should look for a fund custodian who will allow their investments.
The Roth solo 401k answered a critical need for self-employed individuals and sole proprietorships. Unlike traditional employees with relatively stable financial circumstances, their finances are often much more volatile. Limiting them to the relatively low IRA or 401k contributions as originally stipulated meant that in bad years they might not be able to contribute at all, and no matter how good the years were, they would be limited to the low limits on contributions. Allowing them the much larger contributions of the Roth only 401k gave them the opportunity to take advantage of the good years by making much larger contributions to offset the bad years.
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