Question about contributing to both Roth IRA and Self-Directed 401(k) plans

[SomeGuyOnTheWeb]

Hi guys, I have two different accounts: one is a Roth IRA with Acorns, another is a self-directed solo Roth 401(k) plan with Vanguard. If I made $10,000 NET profit in the year of 2023 being self-employed, can I contribute the maximum to the Roth IRA with Acorns ($6,500) and another $10,000 to the self-directed solo Roth 401(k)? Or can I only contribute a maximum of $10,000 total between both accounts? 

Basically wondering if the NET profit requirement for contributions to these accounts applies to each account individually, or all retirement accounts collectively. 

Thank you for any information!

[dmertz · Accepted solution]

Assuming that you are a sole proprietor do not have another job which would cause to to max out the Social Security wage base, with $10,000 of net profit you have only $9,293 of net earnings.  Net earnings are net profit minus the deductible portion of self-employment taxes.

With $9,293 of net earnings you can contribute $9,293 as a Roth contribution to a 401(k) and $6,500 to the Roth IRA.  Only deductible 401(k) contributions reduce the amount of compensation available to contribute to a Roth IRA, so the same dollars used to support the Roth 401(k) contribution can be used to support the Roth IRA contribution.

[SomeGuyOnTheWeb]

@dmertz thank you for this. I have a question which I may have asked you before but need a little clarification if possible please: in a scenario where my tax return shows a NET income of just $1,000 for a given tax year, what happens if I deposit $6,500 into my Roth IRA despite only making $1,000 in NET income? Will I be forced to withdraw the funds from the account, will the funds be double taxed, both or something else? Thank you for any information on this. 

[ThomasM125 · Accepted solution]

You will face a penalty of 6% times your excess contribution to a ROTH IRA. If you contributed $6,500 to a ROTH IRA and your income was $1,000, your excess contribution would be $5,500. You will pay a 6% penalty on that amount every year until you correct the excess contribution, either by removing the funds from the retirement account or by earning enough net income to allow for the excess contribution.

[SomeGuyOnTheWeb]

Thank you so much! Just so I understand correctly: if there is a $5,500 excess contribution one year, then in the next year my NET income is say $15,000, would that make up for the excess contribution in the previous year *and* allow me to contribute another $6,500 to the Roth IRA?

[ThomasM125 · Accepted solution]

Not quite! If you are allowed $6,500 of IRA contributions next year the $5,500 excess from the previous year would reduce that to $1,000 of ROTH contributions allowed in 2024.

[SomeGuyOnTheWeb]

@dmertz 

For 2023 I contributed $4,250 to a Roth IRA. Right now I'm working on my taxes in TurboTax 2023 Home & Business and entered this Roth contribution and it said that the entire contribution of $4,250 was an excess contribution... but my small business NET profit for 2023 was $12,500 and within TurboTax my Form 1040 currently shows a $7,562 Adjusted Gross Income for 2023.  After the $13,850 Standard Deduction however it is showing my "taxable income" as 0... is this the problem? It's still showing that I'll owe about $1,600 in federal taxes though even with taxable income at 0.

I thought IRA contributions were based off of NET earnings not taxable income... should I do itemized deductions instead of the standard deduction to fix this? 

[dmertz · Accepted solution]

The amount available to support a Roth IRA contribution is net profit (Schedule C line 31) minus the sum of the amounts on Schedule 1 lines 15, 16 and 20.

[SomeGuyOnTheWeb]

@dmertz thank you for this clarification. I forgot that I had entered $12,500 for my contributions for 2023 to my Individual Roth 401(k) plan. However, I've actually only deposited $4,250 into this plan so far and $4,250 into another Roth IRA for a total of $8,500 between two accounts and I was *planning* on contributing an additional $8,250 into the Individual 401(k) account. 

With a NET profit for the year of 2023 in the amount of $12,500, how much more can I contribute to my Individual 401(k) account beyond the $4,250 already deposited?

[dmertz]

$12,500 of net profit minus the deductible portion of self-employment taxes, $883, leaves $11,617 to contribute to retirement accounts, assuming no other earnings from another employer.  Having already contributed $8,500 of the $11,617, that leaves $3,117 available to cover additional contributions.

I don't see why you would not want to maximize your traditional IRA or Roth IRA contributions before contributing what remains to the individual 401(k).  The IRAs are generally more flexible, particularly with regard to accessing the funds before age 59½.

[SomeGuyOnTheWeb]

@dmertz earlier in this thread you said the following: "with $10,000 of net profit you have only $9,293 of net earnings. Net earnings are net profit minus the deductible portion of self-employment taxes. With $9,293 of net earnings you can contribute $9,293 as a Roth contribution to a 401(k) and $6,500 to the Roth IRA."

Since I have $11,617  in NET earnings for the year of 2023, shouldn't I be able to contribute $11,617 to the Individual Roth 401(k) plan and $6,500 to the Roth IRA? 

[dmertz]

From your most recent previous reply I had inferred that your individual Roth IRA contribution would be a traditional contribution.  By making at least $6,500 of your $11,617 contribution to the individual 401(k) be a Roth contribution, yes, you could also make a $6,500 Roth IRA contribution because the nondeductible Roth 401(k) contribution does not reduce the compensation available to support a Roth IRA contribution.

[SomeGuyOnTheWeb]

@dmertz think I figured out the issue here. TurboTax is asking me if I opened the Roth IRA prior to 2023. I opened the IRA in February of 2023 and deposited $6,000 based on my NET earnings for the year of 2022 since the deadline for 2022 contributions was April 15th 2023.

The value of the IRA was $7,259 on December 31st 2023. Now I'm making contributions for the year of 2023, but it sounds like TurboTax is assuming that because I opened the Roth IRA in 2023 that my contributions were all intended for the year of 2023? Yet I opened the account and contributed prior to the April 15th 2023 deadline to make a 2022 contribution... am I missing something here? 

[dmertz]

The $6,000 Roth IRA contribution made for 2022 was to be entered as a contribution into 2022 TurboTax, not into 2023 TurboTax.  (Your $6,000 of contribution basis from 2022 will carry forward on the IRA Information Worksheet.)