Self-Employed Retirement Plan Choice, Passive Losses, and Backdoor Roth
Sam, 45, is a married filing jointly consultant with $280,000 of net self-employment income. His spouse has no earned income. They have two children, ages 8 and 11. Sam has a SEP IRA with $150,000 and no employees. He also owns a rental property that generated a $25,000 passive loss this year; his modified AGI before the loss is $210,000. He wants to maximize retirement contributions, reduce income taxes, and fund college. He is considering a solo 401(k), a defined-benefit plan, and a backdoor Roth IRA. His marginal federal rate is 24%, state rate 5%, and he expects the 199A qualified business income deduction to apply. He asks how much he can contribute, whether the rental loss is deductible, and whether a Roth conversion makes sense.
1. Compare the maximum deductible retirement contribution available through a SEP IRA versus a solo 401(k) for Sam, including the effect of the self-employment tax deduction.
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Using 2024 limits, Sam's net self-employment earnings after the employer-equivalent half of SE tax are roughly $265,700. A SEP IRA allows 25% of that, about $66,400, below the $69,000 cap. A solo 401(k) allows an employee deferral of $23,000 plus an employer contribution of 25% of net earnings, but total contributions are capped at $69,000 (plus catch-up if eligible). So the solo 401(k) can reach $69,000, about $2,600 more than the SEP.
A defined-benefit plan could allow a larger deduction, but it requires actuarial certification, minimum funding, and income volatility risk. The solo 401(k) also permits Roth deferrals and loans if the plan document allows. Sam should not use a SEP if he wants maximum deferral. He should coordinate the contribution with the QBI deduction, because the employer retirement contribution reduces qualified business income and therefore the 199A deduction. The planner should compare the tax savings from the extra contribution with the QBI deduction lost, not just the contribution limit.
2. Determine whether Sam can deduct the $25,000 rental passive loss and explain the tax treatment and planning options.
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The $25,000 rental loss is a passive activity loss. The $25,000 special allowance phases out ratably between $100,000 and $150,000 of modified AGI. Sam's MAGI is $210,000 before the loss, so the allowance is fully phased out. He cannot deduct the loss against his consulting income; it is suspended and carried forward.
The loss may be deductible when he disposes of the entire rental interest in a fully taxable transaction. The real estate professional exception requires more than 750 hours and material participation in real property trades or businesses, which is unlikely for a full-time consultant. Grouping the rental with a business is not available for a passive rental. Planning options include increasing his material participation if the facts support it, accepting the suspension, or evaluating a sale. The planner should keep documentation of the suspended loss and model the tax cost of selling, because the suspended loss can offset gain on disposition.
3. Evaluate the backdoor Roth IRA strategy given Sam's SEP IRA balance and recommend whether a Roth conversion of SEP assets is advisable in his bracket.
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A backdoor Roth is inefficient while Sam has a $150,000 SEP IRA because the pro-rata rule aggregates all traditional, SEP, and SIMPLE IRAs. If he contributes $7,000 nondeductible and converts it, about $6,700 would be taxable. The cleaner route is to adopt a solo 401(k) that permits rollovers, roll the SEP into it, and then do a backdoor Roth without pro-rata tax.
A direct Roth conversion of the SEP at a 29% combined marginal rate is a closer call: it may be attractive if future rates are higher or if he wants to reduce RMDs, but it uses cash and reduces QBI. He should max the solo 401(k) first, keep the rental loss documented, and revisit conversions in a lower-income year. The planner should model the conversion against the QBI deduction and state tax. The recommendation is not to convert the entire SEP at once; use the solo 401(k) rollover to enable clean backdoor Roth contributions, then consider partial conversions only if the tax projection supports them.