As a self-employed person, saving for retirement is an important part of effective financial planning. Fortunately, there are several retirement savings options available that offer tax benefits and the ability to save for retirement. Two of the most popular options for self-employed individuals are SEP IRAs and individual 401(k)s, also known as solo 401(k)s.
One of the main benefits of opening a SEP IRA or a solo 401(k) is the tax advantages they offer. Both types of accounts allow you to make tax-deductible contributions, which can lower your taxable income and reduce your tax bill. Additionally, any investment earnings in the account grow tax-deferred until you withdraw the funds in retirement, at which point they are taxed at your ordinary income tax rate.
You might already be familiar with Traditional and Roth IRA’s. While these are both solid choices depending on your situation, the reality is that they each have low contribution limits ($6,000 per year collectively) and have caps to your adjusted gross income. After you exceed a certain profit-level, you may no longer invest in these types of accounts.
Alternatively, the SEP IRA and Solo 401k account do not phase out (although the plans themselves have contribution limits that scale with income).
Now, let’s look at some of the key differences between SEP IRAs and solo 401(k)s.
Contribution Limits
One of the primary differences between a SEP IRA and a solo 401(k) is the maximum contribution limit. Both accounts have the same maximum contribution limit of $58,000 in 2021, and $61,000 in 2022. However, the income level required to contribute the maximum amount differs.
In 2023, individuals making $150,000 or more can contribute up to the $66,000 maximum to a 401(k), whereas SEP IRA owners need to make $264,000 or more to contribute the same amount. This means that a solo 401(k) may be a better option for high-income earners who want to save the maximum amount possible for retirement.
Employer Contributions
Another difference between the two accounts is the way employer contributions are made. With a SEP IRA, only the employer can make contributions to the account, up to 25% of the employee’s compensation or $58,000, whichever is lower. Employees cannot make contributions to their own SEP IRA.
With a solo 401(k), the employer and the employee can make contributions to the account. The employer can contribute up to 25% of the employee’s compensation, just like with a SEP IRA, but the employee can also make contributions up to the annual limit. This means that if you are a self-employed person with no employees, you can contribute as both an employer and an employee, allowing you to potentially save more for retirement.
Loans
One advantage of a solo 401(k) over a SEP IRA is the ability to take a loan against the 401(k). While taking a loan against your retirement savings should be done with caution, having the option to borrow against your solo 401(k) can be helpful in certain situations. For example, if you need to make a large purchase or pay off high-interest debt, taking a loan from your 401(k) may be more cost-effective than using a credit card or personal loan. Specifically, a solo 401(k) allows for personal loans up to $50,000 or 50% of the plan participant’s account value, whichever is less.
Checkbook Control
It is also worth considering the benefits of self-directing your Solo 401(k) and SEP IRA plans. With checkbook control, you can make both traditional investments and alternative investments, such as real estate, precious metals, and cryptocurrencies. This allows you to make any investment you want in a timely matter, without needing to ask for permission to make an investment. The checkbook control structure can be used with both a Solo 401(k) and SEP IRA.
Other Comparisons
If you have no full-time employees, the Solo 401(k) is generally considered the superior option for the self-employed. It is easier to contribute the maximum amount to a Solo 401(k), and it offers some features that are not available with a SEP IRA, such as Roth contributions and personal loans. However, if you have both a small business and other self-employed income, you may consider having both a SEP IRA and a Solo 401(k).
Considerations and Complexities
It is important to note that the employer profit-sharing contributions must be made in pre-tax form, while the employee deferral contribution can be made in pre-tax, after-tax, or Roth as long as the plan documents allow for it. Thanks to the American Taxpayer Relief Act of 2012, if the plan documents allow it, any vested plan balance, including Solo 401(k) plan employee deferrals and employer profit-sharing contributions, as well as earnings, can be rolled over to a designated Roth account, even if these amounts can’t be distributed to the participant.
The Solo 401(k) has several advantages over other retirement accounts, such as the SEP IRA. The Solo 401(k) offers a number of features not found in the SEP, such as the ability to contribute the maximum amount due to the Salary Deferral component and the $6,000 catch-up contribution for plan participants over the age of 50. A Solo 401(k) Plan can offer the owner Roth contributions, even in the case where the owner is otherwise not eligible to contribute to a Roth IRA due to the Roth’s annual income limitation. Unlike an IRA, a special custodian is not required to be used, and most Solo 401(k) Plans can be structured as trustee-directed plans, allowing for faster and more economical transactions.
For corporations (including S corporations), partnerships, and LLCs taxed as either of these:
– The employer can contribute up to 25% of the employee’s compensation.
– The total contributions (employee and employer) cannot exceed $66,000 for 2023 ($61,000 for 2022).
For sole proprietors and single-member LLCs:
– The employer can contribute up to 20% of the owner’s net self-employment income.
– The net self-employment income is calculated by reducing the owner’s gross self-employment income by half of the self-employment tax and the employer contribution.
– The total contributions (employee and employer) cannot exceed $66,000 for 2023 ($61,000 for 2022).
Conclusion
In summary, both SEP IRAs and solo 401(k)s offer tax advantages and the ability to save for retirement. However, they have some key differences, such as contribution limits, employer contributions, and the ability to take loans. It’s important to carefully consider your individual financial situation and goals when deciding which type of account is best for you.
