Solo 401k

401k image

Why would you want to have a Solo 401k?#

There are a few reasons:

  • You have income and are not eligible for a company 401k
  • You have income and you want to use the "company contribution" to increase savings
  • You want access to other investment vehicles out of a 401k
  • You have traditional IRA money that you need to move so that you can do a "Backdoor Roth"

My reason is focused entire on the last one of these. My wife has some traditional and rollover IRAs that make it so that we can't effectively do a backdoor roth without running foul of the pro-rata rule.

important

This is not a fast process. Give yourself a solid 6-8 weeks to do this job so you're not rushed.

How do I set one up?#

I chose to do this all self-service. There are companies that will help you do this, but I couldn't figure out what their value add was for the fees. As an example, the most popular one seems to be MySolo401k. Their fees are $425 for setup and $125 per year after that. Given that I don't need anything complicated I couldn't figure out why I'd spend that money on something that is seems to be reasonably straight forward, if a bit tedious.

Get an Employer Identification Number (EIN)#

Remember, a 401K is an employer retirement plan, which means you need to be an employer to set one up, even if you are your only employee. I'm sure there is a religion somewhere that makes this relationship immoral.

You can sign up for an EIN online. But, for some reason you can only doing it from 0700 to 2200 EST on weekdays. An automated system during business hours. I'm sure this makes sense to someone.

When you do this, you sign up for one as a sole proprietor and then move on.

tip

I would recommend that you make the name of the business different than your own name, just to not confuse yourself. If your name is John Doe and the business is John Doe, it could get confusing which one you're handling. I didn't do this, so it's a free learning for you. Don't over-complicate it though, be simple like "Doe Family" or something else.

tip

If you're doing this just for Backdoor Roth, then you want to reduce your overall hassle. You do need income to open a 401k, but as long as you can legitmately get paid for work, it counts. It doesn't have to be 1099/W2 income, although you may have to report it on your taxes. But, if your business makes less than $600 per year you don't have to file business taxes, which will make your life easier. See the "Not Required to File" portion of the IRS documentation

Figure out which company to have your 401k at#

I did some research on this, and it may be that these change over time, so you might want to double check. Here were my criteria:

  • It had to allow for rollovers
    • Given I was doing this to facilitate a Backdoor Roth, this was a must
  • It had to allow for Roth 401k
    • Ok, this wasn't a must have, but I figured it would be good to have that option in the future.
  • No fees
    • Why should I pay more?

Here are my notes:

  • Vanguard
    • No rollover
    • Roth
  • Fidelity
    • Allows rollover
    • No Roth
  • Schwab
    • Allows rollovers
    • No Roth
  • Etrade
    • Allows rollovers. (Note: It's not obvious when I looked at their site this was the case, but you can find it. They do.)
    • Allows Roth.
  • Spark401k
    • Has fees.
  • TDAmeritrade
    • Has Roth
    • Rollovers?

It's probably obvious, but I went with Etrade.

Open 401k#

Obviously you're going to have to open the account. For Etrade you can find the applications here.

I think the forms are pretty straight forward but tedious. I would recommend filling them all out electronically, and then waiting a few days and going back and reviewing them.

Then you need to get them to Etrade. I was trying to do that in the November timeframe and it was a mess. We mailed them in, and a week later they still hadn't been processed. It was faster for me to upload them from my existing (but unrelated) Etrade account. Then they were processed pretty quickly.

Segment IRAs (pay close attention here)#

You can actually do this step in parallel with other steps because it doesn't have any dependencies. You are doing this so that you can do the Backdoor Roth on your prior contributions.

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This step only applies if you have made after-tax contributions to a traditional IRA. If you only have Rollover IRAs or IRAs that were pre-tax you can skip this.

You want to ensure that you have your cost-basis separated from gains. You should have your Form 8606 to document this. Put all of the basis into something stable like a bond fund, and then move all of the gains to a different fund.

Why is this important?#

Let's imagine that you have a traditional IRA that you have contributed to.

  • One year you contributed $2k pre-tax.
  • One year you contributed $2k post-tax.

Thus, the total value is $4k. You let that sit for a while and decide you want to roll this into your 401k so that you can start doing a backdoor Roth. You plan on retiring in 20 years, compounding annually (it changes some but not much if you go with daily).

At the end of 20 years it will now be worth ~$13000 that you will pay taxes on. Also, you've already paid taxes on the post-tax portion once, so now you're signing up to get taxed on it twice and more importantly you're missing out on the tax-free compounding.

But, if instead you only roll over the pre-tax money into a 401k, and then you backdoor the othe $2k what does that look like?

At the end of the 20 years you have the same amount of money, but now $6500 of it is tax free, and the other $6500 is not. So, if you assume a 15% tax rate, that's nearly $1k or 7.5% less overall. Now imagine you're talking $20k instead of $2k and it magnifies. Or 30 years instead of 20. The numbers just get more compelling.

I screwed this up on my first one, and figured it out and did it right on the second one, but there is no way to undo this, so pay attention.

Now, once you have the 401k setup, you'll be all ready.

Transfer IRAs to 401k#

Finally, you have to transfer the gains from your IRAs into the 401k. I've actually done this twice, once with my employer (401k at Schwab) and once with the solo at Etrade, so recognize it could be provider dependent.

For Schwab I was able to initiate the transfer from Schwab and have it just happen. I filled out the forms and it was all good.

For Etrade, they wouldn't allow me to rollover from an IRA to the 401k. I had to do a qualified distribution from the source (in my case it was T. Rowe Price) to Etrade. This was sort of a pain because I had to fill out the forms, and then get a Medallion Signature Guarantee, which is more complicated.

Honestly, Etrade is kind of a pain for this. They want you to initiate all rollovers from the other company. So, my "Ah-ha" moment was recognizing I should just rollover IRA to IRA at an account at Etrade. Then the process of rolling it over from IRA to 401k is all at Etrade and I can have the conversation with them that goes "Well, why don't you just talk to yourself to get it done?" Then I discovered that that rollover was equally annoying. So, no shortcuts.

important

If you haven't done the MSG before, you have to take the form and the account statements for the source and the destination. Make sure you bring all of the pages of the account statements. I hadn't printed out the 5 of 6 and 6 of 6 pages that were the privacy policy and "This page intentionally left blank" and they needed them.

Now you can Backdoor Roth#

This process is well covered across the interwebs, so I'm not going to go into those details, but hopefully you're now all setup. I link to several of them in the After-tax section.

External Links#

Here are some links that were useful to me when I was doing research.