For Individuals and solo entrepreneurs
Contributing to a retirement plan is important for your financial future, ensuring that you have the resources you need to enjoy a comfortable retirement. Contractors or solo entrepreneurs don’t typically have an employer-sponsored retirement plan. Making sure you have a retirement plan is possible but requires action. There are two great options that are available that will help save money on taxes and help build a secure financial future. A SEP IRA and solo 401k.
A Solo 401(k) is a retirement savings plan designed for self-employed individuals or small business owners with no employees other than a spouse. It's also an Individual 401(k) or a Solo-K. A SEP IRA (Simplified Employee Pension Individual Retirement Account) is a type of retirement plan allowing employers to contribute to a traditional IRA (Individual Retirement Account) for themselves and their employees.
Similarities
- Both plans are designed for self-employed individuals or small business owners, not businesses with full-time employees.
- Both plans offer tax benefits, including tax-deductible contributions and tax-deferred growth.
- Both plans allow for higher contribution limits than traditional IRAs, allowing individuals to save more money for retirement.
- Both plans offer flexibility regarding contributions, as there are no minimum contribution requirements.
- Both plans allow contributions to be invested in various investment options, including stocks, bonds, and mutual funds.
Differences
- Contribution Limits: Solo 401(k) plans have higher contribution limits for less-income SEP IRA plans. In 2023, the maximum contribution for a Solo 401(k) is $66,000, while the maximum contribution for a SEP IRA is $63,000, but the individual must have a $305,000 income. Solo 401(k) plans to offer an additional $7,500 catch-up contribution for those above age 50.
- Eligibility: Solo 401(k) plans are only available to self-employed individuals with no employees other than a spouse. SEP IRAs can be used by any business, regardless of size, and can be offered to employees as well.
- Contribution Types: Solo 401(k) plans allow for employer and employee contributions, while SEP IRA plans only allow employer contributions.
- Administrative Requirements: Solo 401(k) plans have more administrative requirements than SEP IRA plans, which include an annual tax filing once the plan reaches $250,000 in assets. SEP IRA plans do not require yearly tax filings.
- Loan provisions: Solo 401(k) plans can allow participants to take out a loan equal to the lesser of 50% of the plan balance or $50,000. Loans are not available with SEP plans.
How a solo 401(k) works
The Solo 401(k) works much like a regular 401(k) plan offered by employers, but with some key differences. In a Solo 401(k), you act as both the employer and the employee, allowing you to contribute to the plan in both capacities.
With a solo 401(k), as an employee, you can contribute up to $22,500 in 2023 (or $30,000 if you're 50 or older). As an employer, you can contribute up to 25% of your compensation or self-employment income for a combined maximum total of $66,000 in 2023 (or $73,500 if you're 50 or older).
When is a solo 401(k) is better
A Solo 401(k) plan may be better than a SEP IRA for some self-employed individuals and small business owners, especially for individuals with an S-corp that don't take a high salary and take owners' distributions to lower self-employment tax. If they used a SEP IRA would be limited to 25% of that salary.
Solo 401(k) pros and cons
One of the benefits of a Solo 401(k) is that it allows for higher contribution limits than other retirement plans, such as a Traditional or Roth IRA. Additionally, it offers the ability to invest in various assets, such as stocks, bonds, mutual funds, and even real estate.
SEP IRA
The contributions are made solely by the employer and are tax-deductible as a business expense. Employees cannot make contributions to a SEP IRA, but they do have the option to make contributions to their own traditional IRA.
The maximum contribution limits for a SEP IRA are based on a percentage of the employee's compensation, and the employer must contribute the same share for all eligible employees. For 2022, the employer can contribute up to 25% of each employee's compensation or $61,000 (whichever is less).
When a SEP IRA is better
A SEP IRA may be a better option than a 401(k) in certain situations, depending on the needs and circumstances of the individual or small business owner. When a business owner wants simplicity and ease of administration, no requirement on contributions, higher contribution limits to higher earners, and no employee contributions are required.
SEP IRA pros and cons
One advantage of a SEP IRA is that it's easy to set up and maintain, with no annual filing requirements. Additionally, the employer has flexibility regarding how much to contribute each year, as there are no minimum contribution requirements.
However, one downside of a SEP IRA is that the employer must contribute to the plan for all eligible employees, regardless of their level of participation or performance. Additionally, employees may be limited in their investment options, as they can only invest in the traditional IRA investment options.
Real-world contribution examples:
Let's say you're a self-employed consultant with a net income of $100,000 in 2023, you're 45 years old, and you're looking to save as much as possible for retirement. You're considering a Solo 401(k) plan and a SEP IRA. Here's how the math would work out for each plan:
Solo 401(k):
As an employee, you can make elective deferrals of up to $22,500 for 2023. Additionally, as the employer, you can contribute up to 25% of your compensation. Still, it's limited by the lesser of three different calculations considering adjusted net profit, self-employment deduction, and employee contributions. This calculation uses one of those methods. The total contribution limit for 2023 is $41,087 ($22,500 + $18,587).
Here's how the math would work out:
- Employee contributions: $22,500
- Adjusted income: $100,000 minus self-employment tax deduction of $7,065 and employer contributions of $18,587 = $74,348
- Employer contributions: $18,587 (20% of $74,348)
- Total contributions: $41,087 ($22,500 + $18,587)
- Tax savings: Assuming a marginal tax rate of 24%, the $41,087 contribution would result in a tax savings of $9,860 ($41,087 x 0.24).
SEP IRA:
As the employer, you can contribute up to 25% of adjusted earned income which is a similar calculation.
Here's how the math would work out:
- Adjusted income: $100,000 minus self-employment tax deduction of $7,065 and employer contributions of $18,587 = $74,348
- Employer contributions: $18,587 (25% of $74,348)
- Tax savings: Assuming a marginal tax rate of 24%, the $18,587 contribution would result in a tax savings of $4,646 ($4,646 x 0.24).
Schedule a call with a financial advisor.
About the Author
Noah Schwab CFP® is a financial advisor in Spokane, Washington who specializes in helping Spokane small business owners.
- Synergizing business and personal finances
- Setting up retirement plans
- Investment management
Resources:
SEP IRA: Link
Solo 401k: Link
