What is a Roth Solo 401k?

A Roth solo 401k is a retirement saving plan that’s given preferential tax treatment by the United States tax code and is available to the self-employed and sole proprietors. It’s actually two different concepts cobbled together: the solo 401k, and the Roth approach to taxation of retirement funds. The solo 401k permits the self-employed to establish 401k plans with themselves as the only participant, with much higher contribution limits than are available to participants in traditional employer-sponsored 401k plans, and a wide variety of choices for the investment of the funds.

The Roth taxation approach provides that contributions are made with after-tax dollars, contrary to traditional 401k and IRA plans, whose contributions are made with money that hasn’t yet been taxed. Under the Roth approach, though, all the account’s earnings are generally tax-free, so that when a Roth plan is used to fund the taxpayer’s retirement, there’s no income tax liability on the funds when they’re drawn out; when traditional IRAs and 401ks are paid out during retirement, the entire amount is taxed.

The solo 401k has been available to the self-employed and sole proprietors since 1978, when the Internal Revenue Code was amended to establish the 401k, an employer-sponsored plan of deferring compensation and any accumulated earnings. The costs and difficulty of administration, though, coupled with the relatively low contribution limits, made the 401k a poor choice for the self-employed until 2002. New legislation that took effect that year, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), dramatically increased the contribution limits, allowing the self-employed to contribute about 40% of their earnings annually to a solo 401k, making it suddenly a very attractive retirement planning choice.

Roth solo 401k accounts were still fully taxable when drawn out, though. 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 US Dollars (USD) annually — and earnings thresholds. Taxpayers who earned over $120,000 (USD) weren’t allowed to establish Roth accounts.

The EGTRRA extended the Roth taxing principles to 401k plans, but postponed implementation until 2006. This, coupled with the higher limits on the solo 401k, provided the self-employed with a tax-qualified retirement savings plan that would enable them to save relatively large amounts for retirement in a relatively short period of time. The IRS permits Roth solo 401k 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 establishing a Roth solo 401k must identify a custodian for their accounts; if they have special preferences regarding the investment of the funds, they must seek out a funds custodian that permits their investments.

The Roth solo 401k addressed a critical need of the self-employed and sole proprietors. Unlike traditional employees with relatively stable financial circumstances, their finances are often much more volatile. Restricting them to the relatively low IRA or 401k contributions as originally established meant that in difficult years they might be unable to contribute at all, and regardless of how good the good years were, they’d be restricted to the low caps on contributions. Permitting them the much greater contributions of the Roth solo 401k gave them the opportunity to take advantage of the good years by making much larger contributions to make up for the bad years.