The SEP IRA vs. Solo 401(k)–which is the best retirement plan if you’re self-employed? In truth, you can’t go wrong with either. They’re the very best plans available for the self-employed, especially if you’re a sole practitioner
But, let’s take a close look at each and see where they’re similar, where they’re different–and most important–which is most likely to work for you.
Simplified Employee Pension (SEP IRA)
The SEP is an IRA, but you can think of it as one on steroids. Though it works similar to traditional IRAs in most respects, it allows much higher contribution amounts, and therefore a greater tax deduction.
SEP IRA contribution limits
This is where you’ll see the major advantage the SEP has over a traditional IRA. While you’re limited to an annual contribution of $6,000 with a traditional IRA, or $7,000 if you’re 50 or older, the basic SEP contribution can be as high as $56,000 for 2019. Catch-up contributions are permitted for participants age 50 and older, increasing the total contribution by $7,000. That’s a total contribution of $63,000.
One important distinction, however, is that a SEP contribution is limited to a percentage of your income.
According to IRS guidelines, you can contribute up to 25% of your income. But there’s a bit of a glitch in the calculation.
The maximum amount of income you can calculate your contribution on is $280,000. 25% of that amount is much higher than $56,000, so something isn’t right.
The effective contribution percentage limit is actually 20% of your income, up to an annual contribution of $56,000. $280,000 times 20% comes to exactly $56,000. So why does the IRS say you can contribute up to 25%?
According to IRS methodology, the percentage actually works out to be 25% times $280,000, less the amount of the contribution itself.
Based on that logic, the calculation looks complicated, but it actually makes sense.
If you deduct the maximum contribution of $56,000, from the maximum income allowed of $280,000, you’re left with $224,000. If you multiply 25% times $224,000, you come up with exactly $56,000!
To save yourself mental anguish, just assume the maximum contribution is 20%. It’ll work out perfectly, and you’ll keep your sanity.
In case you’re interested, the IRS gives an explanation for this formula. Feel free to check it out, but don’t be too upset if you don’t get it. It’s the kind of calculation computers were invented for.
Adding employees to a SEP IRA
The SEP IRA was established with the self-employed in mind. And you can certainly have one if you’re a sole practitioner. And if you add employees in the future, no problem. You can simply add your employees to the same plan.
Whatever contribution percentage you use for yourself must also apply to your employees. So if you choose 25%, it must be the same for your employees. Obviously, the percentage will be applied to the salary level that each employee earns. If you earn $100,000, the percentage will be applied to that amount. If your employee earns $40,000, the same percentage will be applied to his or her income.
An employee is eligible for participation in a SEP IRA under the following conditions:
- Attained age 21;
- worked for your business in at least three of the last five years;
- received at least $600 in compensation (in 2016 – 2018) from your business for the year.
Setting Up a SEP IRA for Your Business
You start by choosing a trustee to hold and manage the plan. This can be a brokerage firm, a mutual fund family, or a bank. You must also execute a written agreement to provide benefits within the plan.
If you have employees who will participate in the plan, you must also do the following:
- Provide a copy of the written agreement to all eligible employees.
- Give employees certain information about the agreement.
- Set up an IRA account for each employee (the SEP is after all an IRA!).
That isn’t as complicated as it seems. The plan trustee should be able to help you with each of those steps, since it’s a standard process. The IRS even offers the Form 5305-SEP, Simplified Employee Pension-Individual Retirement Accounts Contribution Agreement for this purpose, though the form does not need to be filed with the IRS.
Certain documents will need to be provided to your employees on an annual basis, but your trustee will handle that for you. This must include a plain language explanation of any fees that will be charged on funds withdrawn from the plan.
Other SEP IRA Provisions
SEP IRA investment options. Since a SEP IRA is an IRA, you can also set it up as a self-directed plan. That means you can hold it through any trustee of your choice, and have a virtually unlimited number of investment options.
Roth SEP IRA. You can forget about this provision, because it doesn’t exist. Since a SEP IRA is set up as a larger version of a traditional IRA, you and your employees are free to set up an individual Roth IRA on your own. But there is no capability to create a separate Roth provision within a SEP IRA.
Contribution deadlines. In general, these will match the filing date of your income tax return. That means you can make a contribution as late as April 15, or even your return extension date.
But, if you file a business income tax return, like an 1120S for subchapter S corporations, the contribution deadlines will be based on your business tax return filing date. For corporations, that’s typically March 15, or any extension dates thereafter.
Important note on S Corporations for both SEP IRAs and Solo 401(k)s
Contributions are not calculated based on distributions paid from your Corporation. Those are considered to be dividends, and not earned income.
Your income for plan contributions is limited to the wages you pay yourself from the business. That applies to both the employee and employer contribution portions. In order to maximize your plan contributions from an S corporation for either a SEP IRA or a solo 401(k) you will need to maximize your salary, and minimize your income distributions.
If you’re familiar with a 401(k) plan, then you understand the basics of the Solo 401(k). A Solo 401(k) is basically a 401(k) plan for a sole practitioner.
Since it’s an individual plan, it differs from an employer-sponsored 401(k) in the following ways:
- As the owner of the business, you're both employer and employee with a Solo 401(k).
- It’s not meant for small businesses that have employees (more on that later).
- The plan is however available for the business owner’s spouse (once again, more on that later).
- You can have a Solo 401(k) for all types of businesses. You can even set one up if you are a freelancer or independent contractor. Just about any type of self-employment income qualifies.
Solo 401(k) Contributions
These are the same as they are for an employer-sponsored 401(k) plan.
As an employee, you can contribute up to $19,500 for 2020. There’s a catch-up contribution of $6,000 if you’re 50 or older, making the total contribution $25,500.
Similar to an employer-sponsored 401(k), there is no percentage limitation on the amount of the employee contributions. In theory, you can contribute 100% of your income up to the contribution limits.
But you can also make employer contributions. Similar to the SEP IRA, employer contributions are limited to 25% of your employee income. Total contributions–including both the employee contribution and the employer matching contribution–cannot exceed $57,000 for 2020 (or $63,000 if you’re 50 or older).
Employer contributions are more complicated than they are for the SEP IRA. There are two contribution formulas, one for owners of corporations, and the other for schedule C filers.
In the case of the self-employed person whose business is a corporation, let’s say an S corporation, the calculation is based on your employee income, not necessarily the net profit of the business.
For example, if you take a salary from your Corporation, let's say $50,000, you're able to contribute $19,500 as an employee. You are then able to contribute an additional 25% of your $50,000 salary, or $12,500 as an employer contribution. This will give you a total contribution of $32,000 for the year.
Solo 401(k) contribution for Schedule C businesses
If you file Schedule C, your income for plan contribution purposes is your net business income, less the following:
- One-half of your self-employment tax, and
- contributions for yourself.
By example, let’s say you file a schedule C with a net profit of $100,000. You paid the self-employment tax of 15.3% on that income, or $15,300.
Half of the self-employment tax must be deducted from your net income before calculating your employer contribution. That means $7,650. That lowers your net business income to $92,350.
If you also make an employee contribution of $19,500, that must be deducted as well. That will reduce your net business income to $72,8350. You can then make an employer contribution of 25% of that amount, or $18,212.50.
Your total contribution, both employer and employee amounts, will be $37,712.50.
It’s a complicated process, and my suggestion is to let your accountant handle it.
You can add a Solo Roth 401(k) provision
Similar to an employer-sponsored 401(k), you can also add a Roth provision to a Solo 401(k). This is a big advantage over a simple Roth IRA.
A Roth IRA limits contributions to just $6,000 per year, or $7,000 if you’re 50 or older. With a Solo Roth 401(k) plan, your contributions can be as high as your total employee contributions, or $19,500 (or $25,500 if you’re 50 or older). You can also split your employee contribution between the traditional and Roth portions. For example, you could choose to put $9,500 in each of the traditional and Roth portions. That’s a much more generous Roth contribution than you will get with a Roth IRA.
The employer contribution is limited in a similar way to an employer-sponsored 401(k) plan. Any contributions you make to the plan as an employer must go into the traditional portion of the plan, and not the Roth portion. Since the employer contribution is not considered earned income, it’s not eligible for Roth consideration.
That also prevents the possibility of making the entire Solo 401(k) plan a Roth. Any employer contributions would immediately require a traditional allocation.
Other Solo 401(k) provisions
Adding employees. The Solo 401(k) plan is for sole practitioners. You can add employees, but once you do, the plan converts to a traditional employer-sponsored 401(k) plan. You will then be subject to all the limits and requirements of that plan.
The Solo 401(k) and your spouse. A spouse is the lone exception on the Solo 401(k) plan. Your spouse can work for your business, and participate in the plan, without forcing it into an employer plan. Contributions for your spouse will be based on his or her actual earnings from the business.
Contribution deadline. Any contributions to a Solo 401(k) plan must be made no later than the end of the calendar year, December 31. (Rumor has it there are exceptions–there are for virtually every tax provision–but you should discuss these with a CPA or your plan trustee.)
Investment options. Much like a SEP IRA, or any other type of IRA, a solo 401(k) can be set up as completely self-directed. You can choose the trustee, and have an almost unlimited range of investment options.
SEP IRA vs. Solo 401(k)–Which is the better plan?
In truth, both are pretty good plans. Both have much more generous contribution limits than traditional IRAs. And with the maximum contribution limit of $56,000/$63,000, you can potentially put more money into either plan than you can with an employer-sponsored plan.
In reality, employer-sponsored plans have the same $56,000/$63,000 contribution limits. But because of lower employer matching contributions, the chance you’ll ever get that much contribution is pretty small. This is a built-in advantage for self-employed individuals, particularly those with higher incomes.
On balance, the Solo 401(k) seems to have a few definite advantages over the SEP IRA. The combination of the employee contribution, as well as the employer match, enable you to contribute more on the same amount of income. It also has the advantage of the Solo Roth 401(k) provision, that will enable you to build a large Roth accumulation quickly.
But you can’t go wrong with either plan.