Solo 401(k) to get around pro rata rule
Hypothetical situation:
Client is a 45 year old W-2 employee who’s income is over Roth IRA contribution limits. They have a 401(k) at their job and they also have a traditional IRA with $100k in pre-tax dollars. Let’s say we wanted to start doing some backdoor Roth contributions to have a different tax bucket for retirement. The pro rata rule obviously throws a little wrench into that plan. Assume that either we can’t roll the $100k IRA into his employer 401(k) or we didn’t want to because of poor investment options. The client does not have any side income reported on Schedule C. Could you still open a Solo 401(k) under the client’s SSN as a sole proprietor and roll the $100k IRA in the Solo 401(k) to avoid the pro rata rule? Employee would obviously not make any other contributions to the 401(k) since they don’t have any Schedule C income.
Is there anything that I’m missing or would that be a valid planning opportunity? The potential issue that popped into my head is that if the client were to get audited then the IRS could potentially argue substance over form. I would love to hear your opinions. Thanks!
Permalink Submitted by Alan - IRA critic on Fri, 2024-09-13 10:26
The IRS has not made any explicit warnings about this situation, but it is risky if there is no attempt to even start a business, probably not so risky if a business is started but no contributions can be made because the business is operating at a loss.
Permalink Submitted by Greg Whicker on Fri, 2024-09-13 10:38
Thanks Alan. The more I think about it the more I agree with you that it is probably too risky if there is no other business activity.
Permalink Submitted by Alan - IRA critic on Fri, 2024-09-13 10:45
Like many IRS enforcement decisions, they often wait until a practice is used frequently (eg when the one rollover rule was further limited in 2015, or with respect to wash sales involving IRAs), then they issue specific guidance and begin actual enforcement. And as you indicated, if the client gets audited for any other reason, the IRS will become aware of all their transactions.
Permalink Submitted by A E Lane on Fri, 2024-09-13 19:42
You cannot roll an IRA into a 401k solo or otherwise, unless it was a rollover from a previous employer’s qualified plan and it is a “rollover” IRA. If any contributions were made to the IRA that were not from a previous 401k plan, only the rollover amounts can be transferred to the new 401k.
You can start a 401k if you are self-employed and have self-employment income. If not, hmmmmm. Remember that a solo self-directed 401k cannot have any transaction that is considered self-dealing, or benefits the owner versus the 401k.
I would stay away from that one!!!
Permalink Submitted by Alan - IRA critic on Fri, 2024-09-13 20:39
The limitation of IRA to 401k rollovers to rollover IRAs ended in 2002 (EGTRRA tax legislation). The plan document determines whether the plan will accept an IRA rollover from any IRA or whether they are limited to rollover IRAs. Some plans do not allow rollovers from contributary IRAs out of concern that they will acquire IRA basis, which is not allowed to be rolled into a qualified plan. Some plans that will accept rollovers from contributary IRAs require a signed certification that there is no IRA basis included.