Solo 401(k) vs. SEP IRA – DIGIWIZ CENTRAL

Solo 401(k) vs. SEP IRA

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Either a solo 401(k) and SEP IRA can be a good choice if you’re self-employed or own a small business.

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Solo 401(k)s and SEP IRAs are options for the self-employed and small-business owners to save for retirement. 
These plans are designed for individuals or those with a small number of employees to benefit from tax-advantaged retirement saving. 
The main difference between the two is the way in which you make contributions.

Planning for retirement can be complicated for the self-employed or small-business owners. Two of the most popular approaches are the solo 401(k) and the Simplified Employee Pension SEP individual retirement arrangement (IRA), or SEP IRA. Both offer unique advantages and cater to specific needs. Here is a deeper look at each that can help you decide which is right for you.

See Insider’s picks for the best retirement plans >> 

Solo 401(k) vs. SEP IRA at a glance

A Solo 401(k) is a tax-advantaged retirement plan for self-employed and small-business owners that allows for both employer and employee contributions.A SEP IRA is a retirement savings plan for self-employed and small business owners, allowing employers to make tax-deductible contributions directly to their own and their employees’ IRA accounts.

What is a solo 401(k)?

A solo 401(k) is a regular 401(k) plan that is for people who are self-employed or own a small business with no employees. It enables you to set aside money for retirement into investment accounts and take advantage of tax deferments. 

Solo 401(k)s operate on a pre-tax basis, meaning contributions are tax-deductible, and investments grow tax-deferred until withdrawn during retirement. They follow the same rules for contribution limits, withdrawals, and penalties as 401(k)s that companies provide for employees. The main difference is that the business owner acts as both the employer and employee, which allows for two types of contributions.

Elective deferrals: These can be up to 100% of compensation or earned income (your net earnings after deducting both one-half of your self-employment tax and contributions for yourself if you’re self-employed) so long as it falls below the annual limit. That limit is $23,000 in 2024, or $30,500 if you’re age 50 or older.Employer non-elective contributions: This can be up to 25% of compensation for small-business owners. For those who are self-employed, this contribution is based on a special computation that uses earned income. Total contributions from both elective and employer nonelective sources cannot exceed $69,000 for 2023, unless you are 50 or older and eligible for catch-up contributions.

There are many reasons a solo 401(k) might be a better choice than a SEP IRA for your situation. The first is the higher contribution potential, as both employee and employer contributions can be made. With a SEP IRA, only the employer can fund the account. If you’re a lower-earning business, this can help you reach the $69,000 annual limit more easily than what you’re allowed to contribute with a SEP IRA.

Quick tip: Since solo 401(k)s are usually offered by traditional brokerages, you have options for what kinds of investments you can make with your funds. ETFs, index funds, and target-date funds are just a few.      

See Insider’s picks for the best online brokerages >>

A Solo 401(k) may also allow for loans up to 50% of their account balance, something a SEP IRA doesn’t offer. 

Pros

Cons

Larger contributions are allowed from both employee and employer.

As the employer, you may deduct contributions as a business expense.

Lower-earning business owners can source more funds into retirement savings.

You may be able to take loans against the account balance.

Catch-up contributions are allowed

 Must make regular contributions; no lump sum options.All contributions must be made before the end of a tax year to be counted for that tax year.Lengthy paperwork is required to open.You’re disqualified if you hire even one employee.They can be difficult to change into a SEP IRA.

Solo 401(k) example

Let’s say you’re 45 years old, self-employed, and make $100,000 in earned income. Under the solo 401(k) rules, you can contribute up to 100% of this amount, or the annual maximum limit for employee contributions ($23,000 for 2024), whichever is lower. In this case, you can contribute the full $23,000 as an employee. 

As the employer, you can also contribute up to 25% of your compensation. In this case: $100,000 x .25 = $25,000 

In total, you can contribute $48,000 to your solo 401(k) in 2024: $23,000 as an employee and $25,000 as an employer. If you were using a SEP IRA, you would only have been able to contribute the employer amount of $25,000. 

What is a SEP IRA?

A SEP IRA is a savings plan for employers to use as a way to contribute to their own and their employees’ traditional IRA accounts set up specifically for this purpose. Any employer can establish a SEP IRA, but this option is often a better fit for self-employed individuals and small-business owners. 

See Insider’s picks or the best IRA accounts >>

One of the main reasons is that only the employer can make contributions (up to 25% of their own and/or employee compensation or $66,000 for 2023 ) and whatever they add to their own IRA, they must make equivalent contributions to each employee plan.

SEP IRA contributions are tax-deductible and have tax-deferred growth on the investments. The plan allows for significantly higher contribution limits than a traditional IRA. For 2024, the most you could add to a traditional IRA is $7,000 or $8,000 if you’re over 50. 

Employers have the flexibility to choose what percent they will contribute to their SEP IRAs each year, enabling them to make adjustments based on their business’s financial performance. You’re also not bound to complete contributions by the end of the tax year. You have up until the when you file your taxes, which gives you extra time to determine how much to allocate to your SEP IRA plan.

“It’s a good tool for those with a few employees that you want to incentivize,” says Ryan Derousseau, a CFP® professional and financial advisor with United Financial Planning Group. “But you also want to control when you contribute, since cash flows in your business may be inconsistent. If you have employees, then you have to contribute to the SEP for them. If it’s a down year, you don’t. If it’s a good year, then you can.”

SEP IRA funds are immediately 100% vested, meaning account holders have full ownership of the funds contributed. However, unlike with a solo 401(k), they won’t be able to borrow against the balance of their SEP IRA.

Quick tip: While you can’t take a loan out on a SEP IRA, you can make an early withdrawal. You have to be at least age 59 ½ to take distributions from an SEP IRA without a penalty. If you do so earlier, the amount you take out counts as taxable income and you’ll have to pay an additional 10% penalty.  

 One of the key advantages of a SEP IRA is that it is easy to set up and administer, which can be an attractive option for a solo business owner. There are no administrative costs or annual filing requirements. There is also much more flexibility when it comes to contributions over using a solo 401(k), since there are no requirements to make regular contributions.  

“A SEP IRA may be a better option than a 401(k) in certain situations, depending on the needs and circumstances of the individual or small business owner,” says Noah Schwab, a CFP® professional and financial planner with Stewardship Concepts Financial Services. Those who want simplicity and ease of administration, no contribution requirements, higher contribution limits for higher earners, and no required employee contributions should consider this option, Schwab says.

SEP IRAs also allow for longer exclusionary periods than solo 401(k)s. For 2024, an employee is only eligible to participate in a SEP IRA if they’ve worked for the employer in at least three of the past five years and earned a minimum of $750 for the year.  

“This three-year period is the longest for any retirement plan,” says Matt Bruce, a CFP® professional and president of Pointer Financial Group. “For a 401(k), the minimum eligibility is one year of service and 1,000 hours over that year. For self-employed individuals who may be hiring or who have new employees they aren’t ready to allow in the retirement plan, a SEP IRA allows those employers to exclude those employees for longer.”

Pros

Cons

They’re easy to set up and maintain.

There are no regular contribution requirements.

  

You can continue to offer if you add employees to your business.

All funds are immediately 100% vested

Contributions are tax deductible.

Contribution limits are higher than traditional IRAs.

 You can only contribute up to 25% of compensation or adjusted earned incomeEmployer must make contributions. No employee contributions are allowed.Any funds allocated to the employer SEP IRA must be proportionally added to employee accounts.You cannot borrow against the balance.There may be fewer investment options available.

 

SEP IRA example

Let’s say you’re self-employed as a financial consultant with an adjusted earned income of $100,000 and decide to open a SEP IRA to save for retirement. You can contribute as much as 25% of this amount, up to $69,000. 

$100,000 x .25 = $25,000

You’ll be able to add the full $25,000 to your SEP IRA in 2024 and 2023, since there are no other allowed contributions and this amount falls well below the annual maximum. 

Read the original article on Business Insider
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