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Converting Pretax Self-Directed Solo 401(k) Funds to the Roth Account in 2021 – Items to Consider –

If you are considering converting some or all of your pretax self-directed solo 401k funds to your plan’s designated Roth solo 401k account in 2021, there are some important things to understand before proceeding.

The Deadline is December 31 of Each Year

  • To count for 2021, conversions must be processed by December 31, 2021. This means that the funds and/or assets must be transferred from the pretax solo 401k bank/brokerage account to the Roth solo 401k bank/brokerage account by 12/31/2021.

  • This shouldn’t be confused with the deadlines for contributing to the Roth solo k account. Unlike contributions that can be made up until the tax filing deadline during the following year (2022 in this case) plus extension, the Roth solo 401k conversion rules require the funds and or asset(s) be converted by 12/31/2021.

  • Keep in mind, you may need more time than you think to complete the conversion, if for example, you still need to open the Roth solo 401k bank or brokerage account, so don't wait until the last minute just in case unforeseen issues arise.

Don’t Forget About Taxes

The conversion of pretax solo 401k funds to the Roth solo 401k account is not subject to the 10% early distribution penalty, but it is considered a taxable event.

The pretax solo 401k conversion will increase your ordinary income for 2021, which could potentially cause the loss of exemptions, credits, tax deductions, taxation of Social Security, and increased premiums for Medicare Part B and Part D premiums. Fortunately, this only happens for the year of the conversion. The benefit is that all future qualified distributions (including basis, interest, and gain) from your Roth solo 401k will be received completely tax-free.

When a Conversion is Favorable

Should you convert pretax funds to the Roth account? The answer may be yes if:

  • You do not need your money soon.

  • You expect your future tax rates to be higher than they are today.

  • You are younger. Younger people are generally in a lower bracket and have long retirement savings timelines to work with to grow the tax-free money.

  • Your asset holdings are temporarily down so the amount being converted, and thus the amount subject to taxation, is lower.

  • You want to increase the amount of tax-free money available to you in retirement.

When a Conversion is not Favorable

Conversion may make sense for some but is not for everyone. A conversion may not be a good move for you if:

  • You are older and will need the money soon, as the "5-taxable-year period" rules could apply.

  • You think you will be in a lower tax bracket in retirement than you are today.

  • You do not have non-retirement assets currently available (liquid) to pay the taxes owed on the converted amount.

  • Your asset holdings are temporarily higher in value than normal so the amount being converted, and thus the amount subject to taxation, is higher.

Be Certain

Just like Roth IRA conversions, you cannot change your mind once the conversion has been processed. Be sure that the amount and timing for the conversion makes sense for you and your situation since the money cannot be converted back to a pretax status.

It is recommended to speak with your tax and financial advisors before proceeding with any type of conversion.

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