Solo 401(k) vs SEP-IRA
As a small business owner, reviewing the array of retirement accounts at your disposal can be daunting. In this brief, we seek to help business owners sort through these options and identify some opportunities you can discuss with your CPA.
While there are several retirement savings vehicles available to sole proprietors and contractors, the two favorites in terms of flexibility and savings potential are the SEP-IRA and solo 401(k). SEP-IRA’s were the preferred vehicle of choice up until the passage of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001. The EGTRRA broadly expanded the features available within a 401(k) plan to the self-employed, offering the same advantages of a conventional 401(k) plan without being subject to the complex ERISA rules intended to protect non-owner employees. As solo 401(k) plans have gained popularity in the past several years, costs and complexity of establishing a plan have been dramatically reduced, making them a robust contender against the more traditional SEP-IRA.
WHO SHOULD CONSIDER A SOLO 401(K)?
The Super Saver | In a solo 401(k) plan, you wear both hats as Employer and Employee. This allows you to contribute the maximum employee contribution of $19,500 in 2021 + $6,500 catch-up for those over age 50. As with the SEP-IRA, you can also contribute 20% of your net self-employment income after deducting self-employment taxes as an employer “profit-sharing” contribution. In both plans, you are limited to the lesser of earned income or a $58,000 annual maximum contribution ($64,500 with catch-up). Even more of a “super saver”? Let us know and we can explore options beyond the standard 401(k) or SEP-IRA.
The Super Saver + | In addition to work retirement accounts, you can also save $6,000 per year in a traditional IRA or Roth IRA in 2021 + $1,000 catch-up for those over age 50. High earners (as defined by the IRS and varying by situation) are precluded from (a) receiving a tax deduction for contributions to a traditional IRA and (b) contributing directly to a Roth IRA. Congress has blessed a tactic which allows individuals to bypass the Roth IRA contribution limit by first making non-deductible contributions to a regular IRA and then converting the funds to a Roth IRA – with no tax consequences. The nontaxable nature of this transaction is lost when the individual has any outstanding IRA balances at the end of the tax year (including SEP-IRA’s), as a portion of the Roth conversion will be subject to taxes based on the IRS pro-rata rule. To learn more about advancing this strategy by adding a Roth component to your 401(k), please contact your Woodmont Team.
WHO SHOULD CONSIDER A SEP-IRA?
The Moonlighter | If you can max out your employee contribution through a separate employer’s 401(k) plan, you should take advantage of any match offered to you there. While the maximum employer profit-sharing contribution is assessed on a plan-by-plan basis, your $19,500 employee contribution ($26,000 if over age 50) is applied across plans. So, if you contribute this $19,500 to a separate employer’s plan, you can only contribute the maximum “employer” contribution (20% of net self-employment income) to your own plan whether you have a SEP-IRA or solo 401(k).
The Expanding Entrepreneur | If you plan to grow your roster at some point in the future, you may be better suited to a SEP-IRA. Once you start hiring employees, your 401(k) plan can no longer be a “solo” plan. While a SEP-IRA plan can be extended to your employees, a small business 401(k) plan will subject you to higher costs and maintenance complexities to comply with ERISA requirements.
While these are some highlights, they are by no means an exhaustive list of all the variables to consider. At Woodmont, we value the opportunity to work closely with your CPA to explore options and identify tax strategies that get you closer to achieving your goals.
Please review IRS Publication 560 for detailed guidance on retirement plans for small business. The opinions expressed are those of Woodmont Investment Counsel and are subject to change without notice. The opinions referenced are as of the date of publication and may be modified due to changes in the market or economic conditions. This material is for educational purposes only and does not constitute tax, legal, or investment advice.
Woodmont Investment Counsel is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Woodmont’s investment advisory services and fees can be found in its Form ADV Part 2, which is available upon request.