Playing the 401k to IRA to Solo 401k Rollover Game

Sometimes high-income earners are faced with scenarios that just don’t come about very often for the average wage earner.

It has been said:

Life is what happens to us while we are making other plans.
 

The backstory

That is exactly what happened to me about seven years ago. I had signed a contract with a great group, but as we know the business aspect of medicine is ever changing.  A management company in another city managed us and that company was acquired by a national organization. We had the decision to continue on with the national organization or find a new home for the billing and administrative side of our medical practice.

After doing our due diligence, we found a local company was the best fit for us going forward. We signed a contract with the new management company/anesthesia group and we were back in business.

Since the previous company handled all our retirement benefits, that left me with a 401k from my previous employer. Our current employer didn’t allow rollover of the previous 401k into the new 401k. Of course being the responsible adult, (or so I thought) I rolled the 401k into a traditional IRA so that I would have more control of the expenses and investing options.

This was just a couple years into my private practice after I finished residency.

Within the next few months, I continued to learn more about finance and learned of the back door Roth IRA.

I thought to myself, 

Sweet, as a high-income earner I’m not eligible for a tax deduction on my individual IRA contribution, so I should just convert that money over to a Roth IRA and enjoy tax-free gains forever.

 

Pro rata, two dirty little words

Then I found out about another problem. Some Latin words started to torment me. The phrase pro rata becomes an important part of your life if you were in the situation I was in. Pro rata means proportional. It refers to a proportional allocation in an investing account. Let me break it down for you.

Say I had $45,000 in my traditional IRA that I rolled over from my previous company 401K plan.

Then I contribute $5,000 to my traditional IRA. Remember I am not eligible to take a tax deduction on my yearly traditional IRA contribution because I’m over the limit on my income. You can read more about the limits on deduction in Tax Deductions for High Income Earners.

I’m since I don’t get to take a tax deduction, I might as well roll that money over to a Roth IRA. (Nobody gets a tax deduction on RothIRA contributions but the earning grow tax-free.)

So I convert the $5,000 into my RothIRA. I shouldn’t have to pay any taxes, right?

IRA to solo 401k Rollover

 

I did have to pay taxes.

 

What? I already paid taxes on that $5,000 contribution. Why should I have to pay it again?

In the IRS’s eyes, the entire traditional IRA is one entity. Even if you have three or four traditional IRA’s at different brokerages, they view the whole thing as one big IRA.

In this example since the $5,000 was part of the entire IRA valued at $45,000 + $5,000 = $50,000. The amount I already paid taxes on was 10% of the IRA and the other 90% was contributed before tax. Since I am withdrawing 10% of the total, I would have to pay taxes on 90% of the withdrawal. In this instance, I would pay taxes on $4,500. If I was in the 33% tax bracket that is another $1,500.

 

Now since I’m planning on making an income above the traditional IRA deduction limit for several years to come, I’m going to be paying an extra $1,500 a year for quite some time unless Congress changes the rules.

It sure would be nice to get around that tax rule.

 

There is a way

 

Light descends from Heaven. Cue the angelic music.

 

Enter the Solo401k.

 

If I had never rolled that money over in the first place from my previous employer or if I could get that money out of an IRA account and into a Solo401k I wouldn’t have to pay those taxes.

 

How is this? 

 

The solo401k is a separate account. The IRS doesn’t treat it as an IRA. The trick is getting that bloated IRA money into the solo 401k.

 

I did this about seven years ago. I had a heck of a time finding a brokerage that would accept IRA rollovers to a solo 401k.

 

What are my options?

 

There are several brokers that offer solo 401ks. The top companies I would use are:

 

Charles Schwab: $4.95 commissions and free for Schwab ETF’s

 

Fidelity $4.95 commissions and 91+ commission free ETF’s, no loans

(They allow Traditional IRA to Solo 401k rollovers)

E-Trade $6.95 Stock and ETF commissions, more flexible, allows loans and Roth option

(They allow Traditional IRA to Solo 401k rollovers)

 

Vanguard No commissions with Vanguard ETF’s and mutual funds

 

TD Ameritrade $6.95 equity commissions plus access to their 100+ commission free ETF’s

 

I’ve provided a link above to each solo 401k provider’s application or solo 401k home page. As you can see they all offer very affordable options and quality low-cost index funds or ETF’s. Even if you don’t have money in a traditional IRA that you need to rollover, an individual 401k could be beneficial and any of these companies would serve you well.

For our specific problem, the only company at the time I was attempting to do this that would allow me to rollover my traditional IRA funds was E-trade. They wouldn’t be my first choice in those listed above, but they have served me well over the past several years. My understanding is Fidelity also allows this type of service so you can contact them to make sure it is still possible.

 

Make it happen

Let’s get down to the nitty-gritty and get you on the way to saving some significant taxes.

  1. You need to establish a business. This isn’t hard but there are a few steps. 
  2. First, you need an Employer Identification Number (EIN). You can get that here. The new solo 401k account needs an adopting employer. You can get an EIN for any business. It doesn’t have to earn a certain amount of money, but it needs to be some money. It can be a sole proprietorship.
  3. Open a business checking or savings account and put some business money in there. You can find a free business account here. The money can be from a rental property, babysitting, or selling stuff online. Go drive for Uber if you want for a few days. It doesn’t have to be much money. I used my rental property income and my LLC EIN. 
  4. Now that you’ve established a business, use that business as the adopting employer on the application for E-trade.
  5. Fill out the application. If you have any question they have eager representatives ready to answer any questions at 1-800-ETRADE1.
  6. Initial a Rollover from the Traditional IRA to your new solo 401k.

IRA to solo 401k Rollover

6. Before opening the account confirm that you can rollover the funds from your current institution. Call 1-800-ETRADE1 to go over what you want to do with the representative.

 

Drawbacks

Doing this isn’t all sunshine and rainbows. There are a few drawbacks to consider. 

  1. The rules for early withdrawal are more strict for solo 401k than traditional IRA’s. You have to qualify for hardship before you are allowed to take an early withdrawal and pay the taxes and 10% penalty. Obviously, we would try to avoid this, but your money is overall less accessible. 
  2. You have to have a legitimate business income to contribute to it in the future. You can’t just put $5,000 in there like you can your IRA but since you are making a taxable contribution anyway, you should convert the IRA to a Roth IRA and keep the traditional IRA empty.
  3. If you ever did develop the business to the point of making enough money to contribute to the solo 401k and hired other employees, you would have to amend the plan or start a new 401k to include the employees. 

 

 

It takes a little time to get everything done, but you will be saving a lot of money on taxes for years to come.

If you ever start a business that becomes successful, you will also have a place to put as of 2017 up to $54,000 tax deferred. That’s a lot of tax savings as well.

If you have any questions please let me know in the comments below or email me separately.  I hope that this helps you save some taxes and maybe give you an incentive to start a side business.

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Tom
Tom is a doctor and father of five with a passion for parenting and finance. When he isn't skateboarding, riding BMX, or jumping on the trampoline with his kids, he is reading and writing about personal finance. He helps high income parents educate and mentor their kids to become financially, emotionally, and intellectually self sufficient.

4 Responses to “Playing the 401k to IRA to Solo 401k Rollover Game

  • Thanks for sharing Tom!!! I have heard some really amazing things about solo 401ks. I’m not quite in the position to start funding one but when we’re ready I will definitely use this guide. Thanks for sharing!!!

    • From the looks of your side business you’re gonna need one sooner rather than later. Keep the momentum going!

      Tom @ HIP

  • Nicely said. I have never messed with a solo 401K but have been luck to have employers that allow roll overs. I have made a total of 3 in my career and hopefully am now done (retire or bust…I don’t plan on switching jobs again). The question now becomes when to make the 401K to Roth 401K switch and pay the taxes “pro ratta”.

    • Thanks EJ. Yeah, the allure of the tax free growth in a Roth 401k is enticing. At higher incomes though I’m pretty much resolved to defer tax as long as possible.
      I’m planning on living in a lower tax bracket in retirment and hopefully I’ll have some room within the lower tax bracket then to covert some traditional funds to Roth funds without incurring too much extra tax.
      We’ll see how it plays out.

      Tom @ HIP

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