SEP IRA vs Solo 401(k): Which Should You Choose?Tax Planning
How do you multiply your net worth?
Let the government help.
Here’s how: with both the SEP IRA and the solo 401(k) retirement plans, your investment in your tax-favored retirement
- creates tax deductions for the money you invest in the plan,
- grows tax-deferred inside the plan, and
- suffers taxes only when you take the money from the plan.
Example. You invest $1,000 a month in your retirement. You are in the 40 percent tax bracket (combined federal and state), and you earn 10 percent on your investments. At the end of 30 years, you have $1.58 million in after-tax spendable cash, which comes from (in round numbers):
- $1.2 million in after-tax cash from the retirement plan ($2 million gross less 40 percent in taxes— we’re taking the entire amount out of the plan in this example)
- $380,000 in the side fund (created by investing the $400 of monthly tax savings—$1,000 deduction x 40 percent)
If you had no government help on the taxes and invested $1,000 a month in an investment that earned 10 percent (6 percent after taxes), you would have a little more than $950,000.
Winner. The retirement plan wins by $630,000—after taxes ($1.58 million vs $950,000).
Okay, that’s the big picture. It tells you that tax-advantaged investing multiplies profits. So, do it.
Which Plan Is Best for You?
When it comes to picking a retirement plan, you have many choices. If you have no employees in your business, none of the choices are bad. Let’s start there and say you have no employees.
And let’s say further that you are going to choose between the SEP IRA and the solo 401(k).
Planning point. 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).
Ease of Setup
The SEP IRA 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.
But one filing requirement you need to pay attention to is that once your 401(k) account reaches $250,000 in assets, you must file Form 5500 with the IRS each year.1 And your trustee likely does not do this for you. Further, you may not have engaged your tax preparer to help with this.
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
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, or
- 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.
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.
For purposes of calculating the employer contribution, your compensation or net self-employment income is not reduced by your elective deferral contribution.
- 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
Note that the 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.
Brayden Stout earns $19,000 from freelance work performed as an independent contractor.
Under the solo 401(k) rules, Brayden could contribute almost all of this $19,000 in net earnings to a
- solo 401(k).
- Under the SEP IRA rules, he could contribute only about $3,800 ($19,000 x 20%).
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.
The SEP IRA does not allow a catch-up contribution.
Planning point. The 401(k) catch-up contribution must come from an employee deferral.
Example. Sam Jones, age 53, operates a very profitable C corporation that pays him a big W-2 wage. The C corporation contributes $58,000 to Sam’s 401(k). That’s the employer’s maximum—the lesser of $58,000 or 25 percent of Sam’s W-2 wages. Sam may make an employee elective deferral of $6,500 that reduces his taxable
income for the year and adds to his retirement fund, making $64,500 ($58,000 + $6,500) the total contributions to his solo 401(k) for the year.
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.
Example. Rose Rice, a self-employed engineer under the age of 50 has an annual profit of $120,000.
- With the SEP IRA, Rose can contribute a maximum of $22,304.
- With the solo 401(k), Rose can contribute a maximum of $41,804 ($19,500 as an employee and $22,304 as the employer).
The key to big retirement plan savings is to start early and invest well.
And of course, the more money you can invest well, the more your retirement nest egg grows.
You have several retirement plan options. In this article, we made a comparison for the business owner with no employees other than him or herself (if incorporated) and the SEP IRA with the solo 401(k) and offered the following insights:
- A SEP IRA is typically easier and cheaper to set up than a solo 401(k).
- With the solo 401(k), you have to file form 5500EZ once your plan assets exceed $250,000.
- In most cases, the owner of a one-person business can sock away more money for retirement with the solo 401(k) than with the SEP IRA because the solo 401(k) allows both the employee elective deferral and the employer contribution.