Backdoor Roth Contributions With A Solo 401k (Part 2 of 2)

by | May 18, 2018

 

SEE FULL VIDEO TRANSCRIPT BELOW:

– What’s up, everybody? Justin Harvey here. Happy Friday, I hope you’re doing well.

I want to quickly film part two of a series of discussing the backdoor Roth contribution and how this strategy is available for high-income earning individuals. Specifically, I discussed in the last video, how if you have IRA assets, that is pre-tax, never-been-taxed-before assets in a traditional IRA, then you’re not able to do the backdoor Roth contribution because of what the IRS calls Pro Rata Distribution rule. However, I’m going to discuss in this video, how a physician who has pre-tax IRA assets who is usually not able to do a backdoor Roth contribution is able to, through a series of tax maneuvers and utilizing this account, a solo 401k, how they’re actually able to in the end, begin making a series of backdoor Roth contributions. If you take the impact of this and multiply it overtime, from a tax-planning perspective, it can be very powerful. However, please don’t try this without consulting a tax or financial professional, because there’s more nuance to this strategy than I can adequately treat in three and a half minutes.

But what I’m gonna do now is do a quick case study to illustrate how this is gonna work. So, I wanna introduce doctor number one, who is a 30 year-old attending an anesthesiologist, who after their first years in attending they saved very diligently, they got 36 thousand dollars and a 401k, that they rolled over. So now they have 36k and an IRA. They, later, after rolling this into an IRA, they found out, oh, I’m sad that I have an IRA because I can’t do the backdoor Roth contributions because the Pro Rata rule that messes everything up, as we discussed. So, they want to save 40 thousand dollars a year, they think that this is the best way to do it. Right? So, we got 18k that can go into a 401k, tax deferred, and the rest is gonna be the 22k that’s gonna go into a taxable account, unfortunately that’s the best we can do. Right? So, this physician is gonna do this for five years and with a little bit of investment growth, doctor number one is gonna experience 277 thousand dollars of total savings and that’s gonna be broken down in this ratio here. 126k in a taxable account, 150 in pre-tax account. Now, that’s pretty good, right? We shouldn’t be really disappointed with numbers like these however, there are tax strategies that this physician could have implemented that would have significantly changed the characteristics of some of these savings, would’ve given them significant tax advantage.

So, I wanna introduce doctor number two. Alright, doctor number two, same situation, attending an anesthesiologist, the salary is exactly the same, 330, savings are also the same. They save 36 thousand dollars, they rolled it out into an IRA. From either a 401k or a 403B. However, they know about the Pro Rata rule and they have a smart advisor who’s gonna help them find a way to make backdoor Roth contributions and it involves, my favorite account, the solo 401k. So what they’re gonna do is create a solo 401k and take these assets, the 36 thousand dollars of IRA assets and roll them into the new IRA. I’m sorry, into the new 401k. Now, whenever these assets are rolled over, it needs to be done in a year, when there is some self-employment income. Self-employment income needs to be generated because that’s what’s gonna be used to fund the 401k and it’s gonna give this person the ability to open it. You can’t just open a solo 401k and roll assets into it. But, if you open a solo 401k and have a little bit of self-employment income, from a 1089 or from some consulting work, or from mowing your neighbor’s lawn and claiming that as taxable income, then you’re able to open this 401k account. When you do that, because the 401k now holds the assets there’s no assets in an IRA anymore, this enables you to do the backdoor Roth contribution.

Because there’s no Pro Rata limitation anymore, because this is a 401k account and not an IRA, this opens up this capability that previously did not exist. So now, this same 40 thousand dollars of savings for doctor two is gonna be broken up like so: 18k into a 401k, less a little bit from the self-employment contribution, 16 five into the taxable account, and then five and a half is gonna go into an IRA that’ll be converted into the Roth account. This is the funds that’ll eventually become the Roth contribution through conversion. So, what physician number two experiences is, you’re gonna recognize some of these numbers, 277 is still the total, except look at this, the Roth account has 31 six, so over five years this account has grown to 31 thousand dollars of assets that are never gonna be taxed again, they’re gonna grow tax free, they’re gonna be withdrawn tax free in the future and this physician has just made a brilliant tax move. Compare that again to, you know, physician number one here. You can see the numbers total the same, but look at the composition of the assets. That extra 31k of Roth assets is gonna be a significant tax advantage overtime.

So, hopefully that’s helpful. If you’re in this place where you have an IRA and you thought that you couldn’t do the Roth, the backdoor Roth contribution, think about do you have an opportunity through the use of a solo 401k, and by the way not all solo 401ks will allow you to roll in assets, but some do. So, think about talking to a financial advisor and seeing if this strategy could be open to you to allow you to experience mass attack savings in the years to come.

 

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Herein contains my one-take thoughts on financial concepts, behavioral investing, money management strategies, financial media, and letting you “behind the curtain” on my efforts to help move my physician clients toward financial independence.  Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities, please see my Website Disclaimer page for a full disclaimer.

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