SEP IRA vs. Solo 401 (k) Owners of small businesses have more choices today when it comes to saving for retirement. He now writes The Red Tape Chronicles column at RedTape.Substack.com and hosts a podcast about the unintended consequences of technology. Often referred to as SEP IRA’s, Self-Employment Pension Plans are essentially a type of traditional IRA for self-employed individuals or small business owners. “The primary question many taxpayers ask when deciding between a SEP and a Solo 401(k) is ‘What is the maximum I can contribute?’ In most cases, the Solo 401K allows for a greater contribution and tax deduction, especially in cases where the individual’s self-employment income is limited,” says Dave Cherill, a certified public accountant (CPA) and member of the American Institute of CPAs’ Personal Financial Planning Executive Committee. This post highlights several key advantages of a Solo 401k vs. SEP IRA. Your email address will not be published. The conventional wisdom regarding the Solo 401(k) vs SEP IRA question is that self-employed people should choose the Solo 401(k) because in most cases, the potential tax savings are higher. SEP IRA vs 401k: Some Background The main differences between the three retirement vehicles mentioned above, are going to be the tax benefits and who they are designed to work for. He focuses on cash balance plans and other defined benefit plans. Simplified Employee Pension (SEP IRA), Savings Incentive Match Plan for Employees (SIMPLE IRA), and Individual 401 (k) — sometimes called a solo 401 (k) or a self-employed 401 (k). The funds of a 401(k) plan are invested in the stock market as directed by the employee. We do not sponsor or endorse any investment and are not affiliated with any investment product sponsor or issuer. The maximum limit for 401k contributions is usually much higher than the limit for an IRA. There’s one key feature of SEP IRAs that differentiate them from Solo 401(k)s: Only the employer can make contributions to a SEP IRA account. How Will Your Payment Arrive? To get the best possible experience please use the latest version of Chrome, Firefox, Safari, or Microsoft Edge to view this website. This is called “tax-deferred”, or, taxes are deferred being paid until retirement. There are several tax advantaged retirement plans out there. The SEP IRA and Solo 401k are both business retirement plans. Solo 401(k) plans must be established by the end of the calendar year for you to benefit from the tax breaks for that tax year. Self-Employed Retirement Plan Comparison: SEP IRA vs Solo 401K vs SIMPLE IRA Last updated: January 14, 2021 G.E. At Vanguard, for example, SEP IRA plans can be set up online while Solo 401(k) accounts require a phone call. But it also comes with a lot of responsibilities — not the least of which is saving for your own retirement. But even in some cases where hiring employees simply isn’t in the cards, Henry sometimes advises the self-employed to choose a SEP IRA. For those who qualify for the Solo 401k, they will almost always find that a Solo 401k has certain features that make it the better option. Maximum contributions to a 401k for 2009 and 2010 are $16,500, unless your employer’s plan has a percentage cap that could reduce the amount. Emparion, LLC is a retirement plan document provider. The answer is complicated and is highly dependent on your personal financial goals. “I would say that the biggest benefit of all is the Roth option,” says Desmond Henry, a certified financial planner (CFP) based in Topeka, Kan. “For someone who is a high earner, the Solo makes sense because of the Roth option.”. Solo 401(k)s also offer catch-up contributions for people 50 and older as well as a Roth option, which lets you pay income tax now in exchange for tax-free withdrawals in retirement. The main ones are a 401(k) plan, Simplified Employee Pension IRA known as the SEP IRA, or a Savings Incentive Match Plan for Employees IRA referred to as a SIMPLE IRA. The benefit of a SEP over a regular traditional IRA is that you can take advantage of higher contribution limits than an IRA offers. The SEP-IRA has a contribution limit of 20% of net self-employment (SE) income, after deducting 1/2 of your SE tax. Traditional 401(k)’s have contribution limits of $19,500 (as of this writing) per year, where a cash balance plan allows you to contribute much more. 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. This is what we call a combo plan. The main differences between the three retirement vehicles mentioned above, are going to be the tax benefits and who they are designed to work for. Cash Balance Plans and SEP plans, however, are designed mainly for small business owners and corporate executives. We will take a look here at how the plans differ. But again, with these issues I wouldn’t leave anything to chance. SEP IRA vs 401k: Which is the best plan in 2021? But the differences don't stop there. Right now I have both a SEP IRA and a Roth IRA set up at Vanguard. Second Stimulus Check Calculator: How Much Will You Receive? Employees of the company are allowed to contribute a percentage of their paycheck to a 401(k) plan that is later disbursed to them in retirement. A cash balance plan will allow a business owner in this scenario to contribute more in later years of the business as growth and revenue matures. To help choose the right plan for your business, you need to understand their features and match them to … Here’s the tricky part: Since the Solo 401(k) owner acts as both employer and employee, both types of contributions can be made—and that means most workers can contribute more and receive a higher tax break. Paul has written articles on retirement planning for Inc., Kiplinger and others. For more information on the differences between SEP-IRAs and Safe Harbor … Opening a Solo 401(k) may be somewhat trickier and more time consuming. SEP IRA vs. Solo 401(k) Traditional Considerations. Retirement. Employees must be at least 21 to participate in either of these these plans. Now, if you’re self-employed and have employees and you’re curious as to whether to go with the SEP IRA over the SIMPLE IRA or traditional 401k, I would still say, mostly, no. How to Set Up a Defined Benefit Plan: 5 Start Up Tips, Cash Balance Plan Contribution Deadline: Don’t Miss This Date, Best Cash Balance Plans: The #1 Retirement Structure, Life Insurance in a Cash Balance Plan: 3 Simple Steps, Cash Balance Plan Example: The Simple $189k Illustration, How to Use a Solo 401k When You Only Have Rental Real Estate. Notably, since employee contributions are not allowed, SEP IRAs do not allow catch-up contributions for people 50 or older. Small business owners may benefit more from a Cash Balance Plan because of the age dependent contribution limits. Eligible employersYou qualify to claim this credit if: Amount of the creditThe credit is 50% of your ordinary and necessary eligible startup costs up to a maximum of $500 per year. SIMPLE IRA vs. Solo 401(k) vs. SEP IRA By Barbara A. Friedberg - May 7 , 2016 Saving for retirement has transitioned from the historical, defined benefit pension plan – where your employer took care of the future with a nice pension plan – to more of a, “you’re on your own” type of structure. 401(k) Advantages over SEP and SIMPLE IRAs. Let the battle begin. While SEP IRAs usually have a broader range of choices than 401(k) accounts, the choices are more limited than those available in a standard brokerage account. Employers have to fund every eligible employee's SEP IRA account at up to $49,000 or 25 percent of the employee's total compensation for the 2010 tax year, whichever rate is less. Working for yourself doesn’t mean you have to miss out on the tax benefits that regular employees get from standard workplace retirement plans, though. The SEP, however, is easier to set up and administer. sep ira vs. 401k. What Exactly Can Be Taken From You In A Lawsuit? Self-Employed Retirement Plan Comparison: SEP IRA vs Solo 401K vs SIMPLE IRA Last updated: January 14, 2021 G.E. As for those who are self-employed, I believe the limit is 20% of income to a SEP IRA vs. 25% to a solo 401k. With a SEP IRA you can set aside up to 25 percent of your business’s income, up to $57,000 annually (as of 2020). A Safe Harbor 401(k) plan is a qualified retirement plan that is designed to meet non-discrimination requirements in a more simplified manner than a regular 401(k… This tax-advantaged retirement plan is generally limited to just self-employed individuals, though spouses who work at least part time for them may be eligible to contribute to one as well. IRA vs 401k: Understanding the difference between the two. You have your choice of investments depending on which investment company you use to open the account. If the same worker were 50 or older, they could add $6,500 on to that total. Where Is My Stimulus Check? As detailed above, the Solo 401(k) is the far superior option for the self-employed. SEP IRA vs 401k: How SEP IRAs Compare. Prior to any investment decision, please consult your tax, legal and investment professionals. “In fact, most taxpayers can simply open a SEP account online with their brokerage firm and manage it themselves.”. Any growth on your initial investment is not taxed until retirement. Accounting for exemptions, this works out to be about 20% of earnings for self-employed individuals, as calculated using IRS Publication 560. Required fields are marked *. Solo 401(k)s also offer features more on par with other employer-sponsored retirement plans that SEP IRAs lack: You can, for example, generally take out a loan from your Solo 401(k) equal to the lesser of $50,000 or 50% of your account balance. Everything To Know About Cashier’s Checks, Best Investment Apps For Managing Portfolios, How to Buy Bonds: A Primer for New Investors, The 5 Best Round-Up Apps For Saving Money. You may be able to claim a tax credit for some of the ordinary and necessary costs of starting a SEP, SIMPLE IRA or qualified plan. Many Americans Have Already Received Their $600 Stimulus Payments—Have You? For instance, an entrepreneur who wants to put 10% of their net income into their SEP IRA must put 10% of worker pay into their SEP IRA, too. They are IRA, Simplified Employee Pension aka SEP, a Keogh Plan, or a 401k plan. It’s possible to find custodians who will allow non-traditional investments like real estate or even Bitcoin, but not all providers allow this. Any business with one or more employees is eligible for a SEP IRA, including freelance workers and independent contractors. This is the total amount the employee can personally contribute to all SEP, Roth, and traditional IRAs each year. Schedule a FREE 30 minute call with him: Discover retirement tools and tips to help you save money. What Is The 4% Rule For Retirement Withdrawals? Employees are not permitted to make their own elective contributions, although a solo entrepreneur or self-employed person—who is in effect both employer and employee—may contribute acting as employer. Funds are not to be withdrawn from a 401(k) until said employee reaches at least the age of 59 ½. These plans have different funding rules, and should be looked at closely by a business owner. The Takeaway: Solo 401(k) vs. SEP IRA. If you can’t put away more than $6,000, you should go with the SEP IRA … It allows sizable contributions and big tax deductions. Who Is Eligible For The $600 Stimulus Check? The coronavirus pandemic has only accelerated the trend toward self-employment. To understand what’s different with the QBI deduction in play and whether it’s important to you, let’s review the traditional considerations when choosing between a SEP IRA and Solo 401(k). At the end of 2019, nearly 30% of American workers were self-employed, according to Gallup. Any funds contributed to a 401(k) are not taxed until withdrawn in retirement. Employees in SEP IRA plans must have worked for the employer during three of the past five years and earned at least $550 in 2010. For the 2021 tax year, up to $6,000 ($7,000 for employees age 50 or older). You may have heard of a 401(k), Cash Balance Plan, or SEP (Self Employed Pension plan) among the many retirement vehicle options. Miller 4 Comments While completing my taxes in prior years, I started noticing that I would have a not insignificant tax bill due from self-employment and side project income unless I found a way to reduce my taxable income (especially with full-time … A SEP-IRA has the same overall contribution limit as a solo 401(k). Potentially greater retirement contributions at the same income level, therefore maximizing retirement contributions and valuable tax deductions. SEP IRAs are available from most major brokerage firms and easy to set up. Opening fees and annual fees are often zero. The ranks of self-employed Americans are growing. Hiring just one employee for your business in the future—beyond your spouse—would eliminate the Solo 401(k) as an option. The SEP-IRA limit is up to 25% of an employee’s salary or up to $57,000, depending on which is less. I started a SEP IRA with Schwab and have put 25% of my money into it. We know you have plenty of options. You have two excellent options: SEP IRAs and Solo 401(k) plans. If you have a SEP, it really muddies up the waters if you’re trying to go down that route. They function like a traditional IRA in how funds are invested. Eligible startup costsYou may claim the credit for ordinary and necessary costs to: Eligible tax yearsYou can claim the credit for each of the first 3 years of the plan and may choose to start claiming the credit in the tax year before the tax year in which the plan becomes effective. While the SEP IRA and SIMPLE IRA look a lot like traditional 401 (k) programs, they differ in important respects from that as well as from each other. Defined Benefit Plans | Cash Balance Plans. Saving for retirement is one of the most important financial goals that we need to achieve in our lifetime. Self-employment has many perks. Nearly all brokerage firms offer SEP IRAs, and in most cases they can be opened online. Based on the scope of your business, an SEP IRA may make more sense for your small business than a 401k or other retirement alternative. The main question most self-employed people have – should I open a SEP-IRA or a Solo 401K? For self-employed people, however, a Solo 401(k) may offer greater annual contributions and bigger tax deductions than a SEP IRA, depending on your income. When is comes to the battle of retirement plans, SEP IRA vs Solo 401k, the Solo 401k is the clear winner (if you are self-employed and you or your spouse are the only employees). Schedule Appointment! Editorial Note: Forbes may earn a commission on sales made from partner links on this page, but that doesn't affect our editors' opinions or evaluations. You’ll need an Employer Identification Number, which you can obtain from the IRS if you don’t have one already. Small businesses have 3 basic retirement plan options today – 401k, SIMPLE IRAs, and SEP IRAs. Employees who may be closer to retirement age have higher contribution limits, allowing them to “catch up” on contributing to retirement funds. We often hear from small business owners who are comparing a SEP IRA vs. Solo 401k. When opening an account, be sure to note minimum investment requirements and investment options. Roger Wohlner December 29, 2020. Below is a brief description about each plan, along with key points to consider as we take a look at the SEP IRA vs 401k. Cash Balance Plan Calculator: Illustration in 60 Seconds! And the money you invest in them grows free of taxes. Companies with only a single employee can take advantage of SEP IRAs, meaning they can be a good choice for solo entrepreneurs or gig workers. SEP IRA vs. Solo 401(k) – Which Is Better for You? In most cases, the employee has multiple options of mutual funds to choose from when deciding on investing their contributed money. A formal written agreement is required, known as IRS Form 5305-SEP, but the brokerage will usually take care of that. Keep in mind that cash balance plans also allow you to take advantage of a 401(k) as well as contribute to your Cash Balance Plan. Best Personal Loans For Debt Consolidation. The maximum contribution to an IRA is $5,000 as of 2009. I think I know what the answer is but I just wanted to ask the BP community to … For the SEP IRA, your contributions are 20% of your income which means your business needs to earn at least $275,000 in income before you can max out your contributions. Do You Need To Claim The Second Stimulus Check? I want to have both SEP & Roth 401K. Of that total contribution, $19,500 would be the salary deferral as an employee while $18,587 would be a profit sharing contribution as an employer. Unlike SEP IRAs, people age 50 and older can make additional catch-up contributions of $6,500 a year to a Solo 401(k), bringing the potential total to $63,500 ($64,500 in 2021). This includes self-employed people, sole proprietorships, LLPs, C corporations and S corporations. SEP IRA vs Solo 401K and Backdoor Roth. SEP-IRA and Solo 401K target solo entrepreneurs; an entrepreneur and spouse, and business owners with no employees or contract-only employees. For a sole proprietor, this means that you can set up the plan and make contributions for a given year as late as April 15 of the following year (or October 15 of the following year if you filed for an extension). A tax credit reduces the amount of taxes you may owe on a dollar-for-dollar basis. Most major brokerages offer step-by-step instructions on their websites. “Every situation is different, and an individual should assess the option that is best for their financial goals, but there is some truth to the fact that a SEP is easier to open,” says Cherill. If you’re older than 50, that increases to $6,000. Entrepreneurs who go with an SEP IRA because of potential future hires have another important consideration: All employee contributions must be the same percentage of compensation. So this plan can be particularly advantageous for the self-employed. Unlike a traditional 401(k) plan, SEP IRAs have little to no administrative overhead. When you work for an employer, you can usually count on there being a 401(k) plan or something similar already in place that you can contribute to. The SIMPLE IRA contribution limit is $13,500 with a catch-up limit of $3,000. Ben has two decades of business and finance journalism experience. INDIVIDUAL 401(K) For the 2020 tax year, $19,500 ($26,000 for employees age 50 or older). Those who have full-time employees can save for retirement using a … Unlike SEP IRAs, people age 50 and older can make additional catch-up contributions of $6,500 a year to a Solo 401(k), bringing the potential total to $63,500 ($64,500 in 2021). Funds paid into the SEP IRA are fully tax deductible up to IRS limits, giving the business or self-employed person a dollar-for-dollar reduction in taxable income. So, if your husband has net income of $100,000, he could contribute $18,587 to his SEP-IRA, and substantially more, near double that, to his 401k. Solo 401(k) accounts tend to offer a bit more flexibility in investment choices, too, Henry says. It is only when you hire full-time employees that a SEP IRA makes sense. Forbes adheres to strict editorial integrity standards. As for those who are self-employed, I believe the limit is 20% of income to a SEP IRA vs. 25% to a solo 401k. I just started a business last year and wanted to put some money into retirement. 401(k) vs. SEP & SIMPLE IRAs; 401(k) Advantages over SEP and SIMPLE IRAs. The opinions expressed are the author’s alone and have not been provided, approved, or otherwise endorsed by our. Schedule a FREE 30 minute call with him: A Solo 401(k) is essentially a 401(k) plan designed for individuals. A SEP IRA is simple to administer and no tax filings are required. The term pension in this case is a bit archaic—a SEP IRA is not a defined benefit plan. Congress created the Simplified Employee Pension Individual Retirement Account (SEP IRA) in 1978 to extend the IRA concept to small businesses. SEP-IRA. So in the battle of the SEP IRA vs 401k there are many pros and cons. Paul Sundin, CPA has written on retirement planning for Inc., Kiplinger and others. Unemployment‌ ‌Benefits‌ ‌Boost‌ Calculator, Simplified Employee Pension Individual Retirement Account. It’s easier to max out your Solo 401k contributions vs the SEP IRA. This compensation comes from two main sources. ... For most high income earners, I typically recommend going with the Solo 401k simply because it leaves the Backdoor Roth open. But if you’re self-employed with no employees, the choice depends on how much you plan to save. … But the biggest question is, which one is right for you? These contribution limits will be specified in the Cash Balance Plan documents. If you qualify, you may claim the credit using Form 8881, Credit for Small Employer Pension Plan Startup Costs. For … If you’re deciding between a solo 401(k) and a SEP IRA, and you have employees, the choice is easy: SEP IRA. The maximum SEP IRA contribution is the lesser of 25% of adjusted net earnings or $57,000 for 2020 ($58,000 for 2021). Many business owners will want to reinvest the majority of the business revenue in its initial growth years, not allowing the owner to contribute to retirement in the beginning years of the business. The Solo 401(k) annual contribution maximum in 2020 is $57,000 and $58,000 in 2021. Eligibility requirements are fairly straightforward: Anyone who generates net profits from a sole proprietorship, LLC or other business organization can open a solo 401(k) as long as they have no employees aside from their spouse. Employers can offer a 401(k), a SEP IRA, or SIMPLE IRA, while individuals can set up a traditional or Roth IRA. If funds are withdrawn before this age, a 10% penalty is applied, and the funds withdrawn are taxed as ordinary income. Owners of the small business can also offer a SEP IRA to their employees, and contribute up to 25% of the employees compensation to the account, allowing a small business to offer 401(k) like benefits. There is not a specific numerical number on the limit because it is age dependent. Here is a deep dive report on the important pieces of information concerning qualified retirement plans like 401(k) plans, Cash Balance Plans and SEP plans. In the 3 tax years before the first year you’re eligible for the credit, your employees weren’t substantially the same employees who received contributions or accrued benefits in another plan sponsored by you, a member of a controlled group that includes you, or a predecessor of either. To help support our reporting work, and to continue our ability to provide this content for free to our readers, we receive compensation from the companies that advertise on the Forbes Advisor site. All Rights Reserved. Unlike with a 401 (k) plan, there are no employee contributions. The main ones are a 401(k) plan, Simplified Employee Pension IRA known as the SEP IRA, or a Savings Incentive Match Plan for Employees IRA referred to as a SIMPLE IRA. There are several retirement plan options a small business may want to consider. For example, these plans are set up under different sections of the tax code. There are lower startup costs and operational costs for aa SEP-IRA compared to other retirement plans that would be considered “traditional.”#2. The contribution limits of a SIMPLE IRA vs. SEP-IRA are different too. #1. Rather, it lets the self-employed and small businesses and their employees benefit from simple, tax-advantaged retirement savings accounts similar to personal individual retirement accounts (IRAs). Both accounts allow for people to sock away large amounts of pre-tax income — as of 2018, both SEPs and 401(k)s permit individuals to deposit 25% of their income, or $55,000, … That’s because as employee they can contribute up to $19,500, but as employer they can add onto that up to 25% of their adjusted income for a maximum total contribution of $57,000 in 2020 and $58,000 in 2021. “If you want to invest in the alternative space, you can do that in a Solo 401(k)…like cryptocurrencies, life insurance, metals,” he says. The simple answer to this question is that SEP IRAs are retirement accounts opened by freelancers while 401(k)s are retirement accounts administered by larger companies for their employees. Does it mean I cannot contribute to both SEP IRA and Roth 401K, or I contributed too much to one of them? You can’t open a solo 401(k) plan if you have an employee other than your spouse. One exception is Vanguard, which charges $20 a year, but the firm waives the fee for account balances of more than $10,000. In the $100,000 example above, our hypothetical under-50 worker with $100,000 in annual net profit could make a total contribution of up to $38,087. Just set up and fund by the tax deadline. Whether you are an employee of a large company, small company, or a self-employed individual or owner of a small business, there are retirement vehicles designated for your unique scenarios. The plan may also be referred to as an individual 401(k) or a one-participant 401(k). Even though both the 401k and the SEP IRA reduce my taxable income, I would still get an overall better return if I continued buying cash flowing rental properties with it. Switching from a Solo 401(k) to an SEP IRA at some future date can be a big hassle, Henry warns. The SIMPLE IRA vs. 401 (k) decision is, at its core, a choice between simplicity and flexibility for employers. 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