SEP-IRA vs. Solo 401K

The road from an idea to a profitable business is both exciting and overwhelming. You sacrifice time, work, and talent to build your dreams, so you must protect the fruits of your labor. Choosing the best savings plan can be a burden.

Entrepreneurs have and want to save more money, and what better way than to invest them into a retirement plan! Retirement savings plans for business owners and entrepreneurs differ from the options regular employees have.

Employees save for retirement by using Traditional, Roth IRA, and a 401K, whose limits an entrepreneur can quickly max out. In addition, entrepreneurs have SEP-IRA and Solo 401K, allowing them to make more massive contributions towards their retirement savings.

SEP-IRA and Solo 401K target solo entrepreneurs, entrepreneurs and spouses, and business owners with no employees or contract-only employees.

The main question most self-employed people have – should I open a SEP-IRA or a Solo 401K? Unfortunately, the answer is complicated and is highly dependent on your personal financial goals.

There are two main differences; solo 401K allows you to save more on a lower income and benefit from catch-up contributions over 50. You can also take a loan from the solo 401K. Both of these options are not available with a SEP IRA.

What Is A SEP-IRA?

What Is A SEP-IRA?

SEP-IRA stands for Simplified Employee Pension Independent Retirement Account, and it’s an individual retirement plan that allows you to save a portion of your company’s profits. Best explained, SEP-IRA is a profit-sharing plan.

The difference between a ROTH IRA and a SEP-IRA is that you have higher annual contributions with the SEP-IRA.

Let’s compare; with ROTH IRA, you can save up to $6,000 a year, while with SEP IRA, you can contribute up to $57,000 a year in 2020.

How Does an SEP-IRA Work?

How Does an SEP-IRA Work?

SEP-IRA is often the first choice for young entrepreneurs because it doesn’t have high operating costs or many criteria. To establish a SEP, all you need is to be over 21years old, have at least 3 years of employment, and a $600 minimum contribution.

As an employer, you can change how much you contribute each year. For example, if your business suffers a lousy year, SEP-IRA allows you to skip contributions that year.

For tax purposes, the SEP-IRA is treated as a traditional IRA. Therefore, when you, as an employer or self-employed, contribute to the SEP-IRA, you receive tax deductions for the amount contributed.

Withdrawals from SEP-IRA in retirement get taxed at ordinary rates.

How Much Can You Contribute To A SEP-IRA?

Depending on if you’re a sole proprietor or a corporation, there are different limitations to how much you can contribute.

As a rule of thumb, if you’re a sole proprietor, you can contribute up to 25% of your net business income to a SEP-IRA.

Well, that’s the widely available information. In reality, as a sole proprietor, you have to pay half of the self-employment tax – social security and Medicare.

Let’s simplify it, meet Tom. Tom is a self-employed individual who made $100,000 in net profits this year. Reading articles around the internet made Tom think he can save up to 25% or $25,000 of his net income into a SEP-IRA.

But it’s not that simple. Since he’s self-employed, he has to deduct 7.65% for FICA taxes, leaving him with $92,350 taxable income. Then multiply the taxable income by the self-employment tax rate, which is 15.3%.

This leaves him with roughly 19.5% or $19,500 as the maximum limit he can contribute to his SEP-IRA.

If you’re a corporation or an LLC and you pay yourself a wage, then the amount you can contribute towards a SEP IRA is 25% of the salary that you pay yourself.

When you’re a corporation, your wage is not your only income from the business. So you’re probably getting business distribution, but you can’t contribute to a SEP IRA based on business distributions as a corporation.

Would you like to meet John? John is a doctor who has a professional corporation and pays himself $100 000 in wages and gets $50,000 in business distributions. However, he can only contribute to his SEP-IRA up to 25% of his pay or $25,000 maximum a year.

Setting Up A SEP-IRA

The greatest thing about SEP-IRA is that you can open an account and fund it by your tax filing deadline, including the extension.

Perhaps you found out you’re eligible for SEP-IRA in February, or you made significant income last year and want to save it; you have until April or July to set up your account.

Procrastinators love SEP IRA.

What Is A Solo 401K?

What Is A Solo 401K?

Solo or individual 401K is a retirement savings plan available to small business owners, self-employed entrepreneurs, and their spouses. The solo 401K is a variation of the regular 401K, but the employee and the employer are the same, so the contribution limit is higher.

Contributions made towards a solo 401K plan are tax-deductible and save the sole proprietor a great deal in taxes.

How Does Solo 401K Work?

The solo 401K mostly follows the same rules as the regular 401K. It’s suitable for sole proprietors, LLC, corporations, and partnerships. If employed at the same business, the business owners and their spouses are eligible for the Solo 401K. You lose your eligibility once you hire outside employees.

You must start withdrawing the minimum required distribution no later than 72 years old, and there is a 10% penalty for withdrawals before the age of 59.

How Much Can You Contribute To A Solo 401K?

How Much Can You Contribute To A Solo 401K?

A Solo 401K has the same maximum contribution as SEP IRA ($57,000 for 2020). The difference is how we calculate the maximum contribution. With a solo 401K, there are two types of contributions: employee deferral and profit share portion.

A regular employee in a corporation has a maximum employee deferral of $19,500. As a self-employed, that is your maximum employee deferral you can contribute towards a 401K. But as a business owner, you can contribute 25% of your net business income.

So with a solo 401K, you can contribute:

  • $19,500 as an employee deferral
  • 25% as profit share.

Let’s say Tom chose solo 401K instead of SEP-IRA. He can contribute
$19,500 as an employee and an additional $19,500 as a profit share of his net income.

That totals to a $39,000 maximum contribution for 2020 with a solo 401K, assuming a $100 000 net income.

Remember John? He switched to solo 401K, and he can contribute $19,500 as his employee deferral. Since he pays himself a salary through his corporation, he can contribute 25% of that salary.

That totals to a $44,500 maximum contribution to his solo 401K.

Setting Up A Solo 401K

Setting Up A Solo 401K

Setting up a Solo 401K can be both expensive and free of charge.

Custodians often charge for setting you up a Solo 401K, but some places offer a prototype plan for free. After that, you’ll only need a tax advisor to help you set it up to make sure you follow all the requirements.

Fidelity and TD Ameritrade have no fees, and Vanguard has a $20 per fund per year. So it’s not simple, but it’s manageable.

It’s important to notice that you don’t have to fund it, but you must set it up by December 31st of the year you want to contribute.

Catch-Up Contributions After 50 with SEP-IRA and Solo 401K

Catch-Up Contributions After 50 with SEP-IRA and Solo 401K

The catch-up contribution is the opportunity to contribute a specific amount above the limit toward your retirement plan after 50.

The main disadvantage of SEP IRA there is no catch-up contribution; no matter how old you are, $57,000 is the limit for 2020, and you can’t contribute a penny more.

With solo 401K, if you’re 50 or older, you can contribute $6,500 more on the employee portion. So if you want to catch up on your retirement savings with a solo 401K, you can contribute up to $26,000 under the employee deferral part.

The Verdict

The final verdict over SEP-IRA or a Solo 401k

Retirement savings plans are not one size fits all.

Depending on your current financial situation, your business forecast, level of income stability, and desire to save, you need to make a choice. While both plans are great, the 401K offers you significantly more.

SEP-IRA is a great retirement plan for younger entrepreneurs, freelancers, and small businesses with varying profits. It’s straightforward to set up, and there is less paperwork involved throughout the years.

If you don’t think you’ll be able to max out the SEP-IRA limit, then there’s no need to look into a solo 401K.

Solo 401K helps you save a lot faster; if you can afford to contribute up to 44% of your income, this is your best choice. Especially if you’re nearing 50, a solo 401K can be a fast-forward button for saving more for your retirement. You can enjoy the benefit of taking a loan from your retirement savings.

If you’re self-employed, do you have a retirement plan set up? What’s your choice and average contribution?

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