SEP IRA vs Solo 401(k): Which Should You Choose?
Have some of you reached a point where the future now includes thinking of your retirement? Technically, you should always think of your retirement. I mean who doesn’t want to retire early and live out their days doing what they love instead of working? For us, (enter throat clearing) who are now old enough- I’m going to stick to wise enough- to make that leap into saving for the future. This is something that you can do even as a small business, you don’t have to be a giant corporation to save for retirement.
So there are two main options you can use to help you save money now and save money later! (Did I get your attention with the saving money now?)
The SEP IRA -Simplified Employee Pension Individual Retirement Plan- That’s a mouth full so we will stick to SEP IRA and the Solo 401 (k) retirement plan. In this article I will explain the differences, benefits and disadvantages of each.
The good news is that no matter which one you choose, you are saving money for the retirement villa, or boat awkwardly named after your dog, or my personal favorite vacationing around the world!
Here are the benefits to both the SEP and the SOLO 401(k) when it comes to taxes:
- Your investment in your tax-favored retirement
- Creates tax deductions for the money you invest in the plan (this is the saving money today part)
- Grows tax-deferred inside the plan, (this is the growing money for the future part)
- Suffers taxes only when you take the money from the plan. (in the meantime you are not paying taxes on the money now- more saving money today)
With out a retirement savings plan, as in you sock the money under your mattress or even keep it in a savings account.
This money is considered after tax money. Meaning you have already paid taxes on this money. Sounds like that would save you money later, if you paid these taxes now. Except, most Americans’ tax bracket (the percentage you pay in taxes) is considerably lower once you retire, so you would be paying taxes at a hire rate now.
Setting up a SEP IRA or Solo 401 (K) used pre-tax money, meaning you haven’t paid taxes on it yet, but when you do pull the money out, your tax rate should be lower, hence paying less taxes overall! (Yay tax math!)
Which Plan Is Best for You?
When it comes to picking a retirement plan, you have many choices. Today we are focusing on the SEP IRA or Solo 401 (K)
This begins to get more complicated if you have employees, but for the sake of our sanity we will start with you business having no employees. If you have no employees in your business, none of the choices are bad. Let’s start there and say you have no employees.
Something of note: As a one-person business, you can operate as a C or S corporation, single member-LLC, or proprietorship and have either the SEP IRA or the solo 401(k).
Easiest to Set Up
The SEP IRA
This option is easier to set up—but there’s no rocket science required to establish a 401(k) plan.
You do have to pay attention to the solo 401(k) requirements, as they can change, but in general, your trustee is going to help you stay in compliance. If you don’t have a trustee, find a financial planner, or use one of the big investment firms like Fidelity, Charles Schwab, or Ameriprise. They are always willing to help a small business get started.
(At no point, do I endorse any of these companies. These are just the three that came to mind as I am writing this article.) I do however have my personal finances and favorite financial advisor. If you are interested, I will gladly pass on the information. Just shoot me an email info@cdprofessionalservices.com to discuss.
Solo 401 (K)
This one can be more complicated (not by much) because there are some filing requirements with the IRS. That is if you 401 (K) reaches $250,000 in assets, you must file Form 5500 with the IRS each year. But let’s face it, if your 401(k) reaches $250K congrats! You have reached a goal most American dream of! So filing Form 5500 doesn’t seem like such a terrible inconvenience anymore now does it! Your trustee likely does not do this for you.
Further, you may now have engaged your tax preparer to help with this. (Shameless plug: a good Bookkeeper can assist with that.)
Beginning with tax years 2020 and later, the IRS has made the Form 5500 EZ mandatory for use by the solo 401(k) with $250,000 or more in assets, and it’s available for either online or paper filing.
The SEP rules do not require you to file Form 5500.
Why Choose a Solo 401(k)?
There are reasons to choose a solo 401(k). For one, if your goal is to stash away as much cash as possible, then a solo 401(k) may be an option worth looking into—especially if your income is on the smaller side.
With a solo 401(k), annual deductible contributions to the business owner’s account can come from two sources.
Source 1 (You): Elective Deferral Contributions
Money you as the ‘employee’ in your own business set aside from your paycheck.
For 2021, you can contribute to your solo 401(k) account up to $19,500 ($26,000 if age 50 or older) of
- Your W-2 income if you are employed by your own C or S corporation
- Your net self-employment income if you operate as a sole proprietor or as a single-member LLC that’s treated as a sole proprietorship for tax purposes.
(Chaching!)
Source 2 (Your Business): Employer Contributions
On top of your elective deferral contribution, the solo 401(k) arrangement permits an additional employer contribution of up to 25 percent of your corporate salary or 20 percent of your net self-employment income.
(Double Chaching!) Say you make $25,000 a year. Your company can contribute up to $6250.00 toward your Solo 401 (K)- this is all pre tax money- save today, save tomorrow)
Your company calculates your salary before your own contribution to your 401 (k) so your contribution is calculated on your full salary!
- With a corporate plan, your corporation makes the employer contribution on your behalf.
- With a plan set up for a sole proprietorship or a single-member LLC, you are effectively treated as your own employer. Therefore, you make the employer contribution on your own behalf.
Strange, But True: a one-person business is both an employee and an employer for the solo 401(k).
SEP IRA Has One Leg
With the SEP, you look at the employer contribution only—which is up to 25 percent of your W-2 wages if you operate as a corporation or 20 percent of your self-employment income, as adjusted.
In other words, you as the employee don’t make any contributions, you as an employer can contribute up to 25%. This helps the company when it comes to its taxable income for tax purposes, but does not help you as an individual taxpayer as you did not make any contributions toward your retirement personally.
High Income
If you are under age 50 and your income is on the higher side, the 2021 ceiling on contributions is $58,000.
But if you are age 50 or older, the solo 401(k) has a catch-up provision that allows you to contribute another $6,500, creating a maximum 2021 potential of $64,500. (Meaning you are late and need to catch up on your retirement)
The SEP IRA does not allow a catch-up contribution. (Sorry!)
Something else of note: The 401(k) catch-up contribution must come from an employee’s contribution.
Key Comparison
The SEP IRA contribution can be made only by the employer—employee contributions are not allowed!
The solo 401(k) plan allows both employer and employee contributions.
Examples of both types of retirement contributions: Eddie Gomez, a self-employed entrepreneur under the age of 50 has an annual profit of $120,000.
- With the SEP IRA, Eddie can contribute a maximum of $22,304.
- With the Solo 401(k), Eddie can contribute a maximum of $41,804 ($19,500 as an employee and $22,304 as the employer).
At the end it all depends on what you and your company can afford. The one thing you should take from this article is to make a plan about your retirement and put it into action!
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