For years, the SEP-IRA was considered the go-to choice for self-employed folks to slash their tax bills and save for retirement. Alternatively, plans like the 401(K) were thought to be only for large corporations with big budgets to spend on running their plan.
Times have changed and today, Solo 401(k) plans are the new king of self-employed retirement plans . Sometimes called the Solo K or Individual K.
Individuals earning less than $220,000 will likely be able to contribute more to a Solo 401(k) versus a SEP-IRA or SIMPLE IRA.
Larger contributions allow for more tax deductions and more tax deductions result in lower tax bills.
More retirement contributions should also equate to more retirement income.
What has changed for Small Business Retirement Plans
The big change is the cost to open and maintain a small business 401(k) has been reduced. Previously, the SEP-IRA was easier and cheaper to open.
That is still likely the case today at most retirement account custodians, but the cost gap has shrunk.
The extra hassle and cost to open a 401(k) is more than offset by the potential to contribute more money, pre-tax. In many cases, opening a solo 401(k) requires a few extra signatures and making contributions as both the employee and employer.
That could be as easy as writing two separate checks.
When joining the ranks of the entrepreneurial class, the responsibility to set up a retirement plan for your small business falls squarely on you.
Entrepreneurs are busy and saving for retirement is likely not on the top of their lists.
But it should be.
Uncle Sam wants a chunk of your profits and thinking strategically, and planning ahead to minimize taxes, can help make your business more profitable.
Remember, it’s not what you make, but what you keep.
There are plenty of options to get tax breaks on your retirement accounts.
You just need to know which account will be best for your situation compared to which one will be the easiest and cheapest to maintain.
For those who are eligible, the Solo 401(k) will likely be the best way to maximize you pre-tax contributions and reduce your tax bill.
Let’s be real. Tax savings is often the main motivator for most business owners to contribute to retirement accounts.
Will you be able to use a Solo 401(k) to maximize your retirement contributions?
For this conversation, I’m going to assume you have some self-employment income.
That could be income from a side hustle or from full-time income like running a small business.
In my case, I own a financial planning firm. Individuals, like us, have a few options beyond a basic Roth IRA or Traditional IRA.
These include the SEP-IRA, Solo 401(k), Cash Balance Pension Plan and even a SIMPLE IRA.
The Solo 401(k) is generally reserved for those without employees, other than themselves and perhaps a spouse. A Solo 401(k) can technically be opened anywhere and fees vary dramatically.
You will usually find better guidance from fiduciary advisors working at a RIA.
Advisors who work at a Wirehouse or Broker Dealer will likely have onerous paperwork and fees and will likely steer you towards the more basic SEP-IRA.
Remember you can make pre-tax retirement contributions to a Solo 401(k) and you get the benefit of contributing as both the employee and the employer.
This is where the Solo 401(k) reigns king of small business and self-employed retirement plans.
Contributing as both the employee and employer almost always allows you to contribute more to your retirement accounts compared to a SEP-IRA.
Forget about the SIMPLE IRA.
In my opinion, there is no point contributing to this type of retirement account unless you have employees.
Even then, you will likely find life to be easier with a full-sized 401(k) profit sharing plan.
Let’s take a closer look at why a Solo 401(k) is kicking the SEP-IRA to the curb.
This is specifically for anyone looking to minimize their small business tax liability with the added benefit of saving more for retirement.
Contribution Limits - Solo 401(k) versus SEP-IRA
Both have contribution limits which may lead you to believe that both plans are basically equal.
In reality, there are fun calculations that need to be made to determine how much you can actually contribute per year. On paper they may appear to be the same, in practice the allowable contributions can differ dramatically.
Solo 401(k) - Contribution Limits as an Employee
You can contribute up to $18,500 in 2018 as an employee of your business.
You can also make a $6,000 catch up contribution if you have reached the fabulous age of 50.
The big caveat is that your contributions can’t exceed your salary or earned income.
Earned income equals your net earning minus half of your self-employment taxes and 401(k) contributions. Don’t worry. It’s not as complicated as it sounds.
Solo 401(k) - Contribution Limits Acting as the Employer
You can make a profit-sharing contribution up to 25% of compensation or 20% of earned income. This is above and beyond the above-mentioned employee contribution of up to $18,500. The total contribution limit for Solo 401(k) plans in 2018 is $55,000. That limit jumps to $61,000 for those 50 years of age and older.
Contribution Limits to a SEP-IRA
The total contribution limits to a SEP-IRA appear similar to solo 401(k) limits, capping out at $55,000 for 2018.
However, the reality of the maximum you are able to contribute will vary between these two small business retirement accounts.
One major difference is there isn’t a catch-up contribution for individuals who are 50 years of age and older with a SEP-IRA.
Additionally, it’s only for self-employed individuals and allows them to make contributions of up to 25% of their salaries, or 20% of earned income.
There is no contribution as an employee for a SEP-IRA.
The math is simple. The Solo 401(k) is king.
Whether you open a SEP-IRA or Solo 401(k), you have essentially the same contribution limits as the employer.
Again, what you are actually allowed to contribute, and how that is calculated varies between the SEP-IRA and Solo 401(k).
For a Solo 401(k) you can still contribute up to 25% of your salary or 20% of profits as the employer.
Additionally, you also get to contribute as an employee to the Solo 401(k) which can essentially increase your contributions by $18,500.
Or potentially $24,500 if you are 50 or older.
Only time SEP-IRA is the best choice
Let’s lay this out for you. If you make an adjusted gross income of $220,000 or more, you’d be able to contribute the same amount to a SEP-IRA as the Solo 401(k).
This is assuming you are younger than 50.
The Solo 401(k) wins as the better option for those who are 50 and older because of the catch-up contribution option.
For all the procrastinators out there, the deadlines to open a SEP-IRA and Solo 401(k) differ. If you are reading this after the tax year has ended, but before you file your taxes, the SEP-IRA is your new retirement plan.
The reason being that the solo 401(k) must be set up before year end but you have until you file taxes to fund it.
On the other hand, a SEP-IRA can be opened and funded up to the date you file your taxes.
This includes filing an extension which gives you extra months to save, open and contribute for the prior tax year.
What is the best retirement plan for your business?
The most important thing is to save money for retirement and lower your current taxes.
Solo 401(k)s, SEP-IRAs or SIMPLE IRAs are all positive choices when it comes to saving money.
If you are already maxing out your current retirement go for extra credit and look into a Defined Benefit Pension Plan.
This super-sized retirement plan may allow you to contribute an addition $100,000 pre-tax per year depending on your age and income.
The Solo 401(k) is clearly the big winner for those who are eligible to use them. You will have an easier time making larger, pre-tax retirement contributions. Larger contributions lead to bigger tax deductions which is a win-win.
The GOP/Trump tax plan may make the contribution even more valuable to whichever retirement plan you choose.
Staying below certain income thresholds will allow you to keep the new 20% pass through tax break.
Talk to a tax pro or certified financial planner to see which plan will help you keep the most of your hard-earned money.
