Updated for 2020. Self-employed business owners have several retirement plans to choose from, and for small companies, the SEP IRA and Individual 401(k) are the most common. Determining which plan is best suited for you will depend on certain information about your business, savings goals, and investment management strategy. Additionally, number of employees, business earnings, annual income and business entity structure will also determine eligibility and potential tax advantages. This article provides an overview of each type of retirement plan as well as the differences between a SEP IRA and Individual 401(k).
Overview and Eligibility Requirements
The Individual 401(k) plan is very similar to a Traditional 401(k) plan, with profit-sharing provisions. For business owners who do not plan to take on additional employees in the future, a Solo 401(k) offers a higher contribution limit, tax-deferred growth, a wide array of investment options, and loan provisions.
The Individual or Solo 401(k) is only suitable for self-employed individuals or the owners of a small business (sole proprietors, partnerships, C and S corporations) with no other employees, unless that employee is a spouse. If you have other employees or expect to hire in the future, this may not be the best option for you.
How Much You Can Contribute to an Individual 401(k)
Contributions for a Solo 401(k) are comprised of two parts: an elective individual contribution and a profit sharing contribution:
- The maximum elective deferral in 2020 is the lesser of $19,500 ($26,000 if over age 50 due to the $6,500 catch up contribution) or 100% of W-2 compensation or net self-employment income. In 2019, the limit is $19,000 and $6,000, respectively.
- A profit sharing contribution can also be made of up to 25% of W-2 wages (if taxed as a corporation) or 20% of net self-employment income for a partnership, sole proprietorship, or single-member LLC that has not elected to be taxed as a C-corporation or S-corporation. In 2020, the annual compensation limit for eligible wages is $285,000, up $5,000 from 2019.
Solo 401(k) Tax Benefits
The Individual 401(k) offers tax benefits like other qualified retirement plans. For sole proprietors, the employee and employer contribution will be combined as an above-the-line deduction on your tax return.
If your business is taxed as a C-corporation, S-corporation, multi-member LLC or partnership, the tax benefits will be split in two parts:
- Your individual contributions will reduce your W-2 taxable income as an above-the-line deduction.
- The profit sharing contribution from the business will be deducted as an expense by the business, reducing the company’s net taxable income, which then reduces the taxable income that will be passed through to an owner on their K-1.
Other Key Facts About the Individual 401(k):
- Loan options – potentially penalty-free loans may be taken, subject to certain limits
- Contribution flexibility – the Solo 401(k) allows discretionary contributions to be made by both the individual and the business. Further, the availability of the catch-up contribution after age 50 may allow business owners to save more compared to other types of qualified retirement plans
- Roth contributions permissible – just like other 401(k) plans that have a Roth component, an Individual 401(k) can be designed as either a Traditional Solo 401(k) or a Roth Solo 401(k) plan. There are no income limitations for contributions to a Roth Solo 401(k) although annual additions are still aggregated by the individual and cannot exceed the overall limitations. (Note: only individual deferrals may be allocated to Roth plans)
- Administration – required annual reporting through Form 5500 once the accumulated sum reaches $250,000
- Deadline to establish plan - December 31st
Simplified Employee Pension (SEP IRA)
Overview and Eligibility Requirements
The SEP IRA is a type of a Traditional IRA, however it is specifically for small business owners
(sole proprietors, partnerships, C and S corporations), and those that are self-employed. Employers can contribute to this retirement plan for themselves, as well as their employees.
All SEP IRA contributions are made by the employer – employees generally cannot contribute to this type of retirement plan. Since the SEP IRA is a type of IRA, the same rules will apply – for example, IRAs do not permit loans and cannot invest in life insurance.
Any employer with one or more employees can establish a SEP. Unlike a Solo 401(k) which does not allow for non-spouse employees, a SEP IRA must cover all eligible employees. An employee is considered eligible if they are over the age of 21, have worked at the company for at least three of the last five years, and received at least $600 (in 2019 and 2020) in compensation for the business year.
How Much You Can Contribute to a SEP IRA
SEP contributions are limited to the lesser of 25% of W-2 earnings for entities taxed as a corporation, or 20% of net earned income if self-employed, up to an annual compensation limit of $285,000. The maximum funding is $57,000 in 2020.
It is important to note that when SEP contributions are made, they must be done equally across all eligible participant accounts, whether as a flat dollar amount or equal percentage of compensation. Employers do have discretion as to whether to make an annual contribution and in the amount, but the decision must be applied uniformly across all participants and within specified limits.
Due to the eligibility requirements and required uniform contributions, SEP IRAs are most commonly used by self-employed business owners without any employees.
SEP IRA Tax Benefits
As in the Individual 401(k), for sole proprietors, the SEP contribution will represent an above-the-line deduction on your personal tax return. If your business is taxed as a C or S corporation, multi-member LLC or partnership, the SEP contributions will be deducted as a business expense, reducing the company’s net taxable income, which then reduces the taxable income that will be passed through to an owner on their K-1.
Other Key Facts about the SEP IRA:
- Most flexible plan to set up and fund – SEP IRAs can be set up and funded as late as a tax filing extension and still count towards the previous calendar year
- Administration – SEP IRAs are not subject to annual IRS filings
- Impact on other IRA contributions – Unless a SEP plan allows for employee contributions, employer contributions generally will not impact the ability to make annual additions to a Traditional or Roth IRA, subject to annual limitations and income thresholds for tax-deductible and Roth contributions
Which is better: the SEP IRA vs. Solo 401(k)
All else equal, an Individual 401(k) usually provides a greater tax-deferred contribution opportunity compared to the SEP IRA due to the employee contribution and catch-up provisions. The Solo 401(k) also offers benefits not available in a SEP IRA, such as plan loans and a Roth feature. There are, however, two main drawbacks of Individual 401(k) plans: the inability to have employees and added complexity of administration and the possibility of reporting.
For many solo entrepreneurs, the best retirement plan often comes down to funding goals and cash flow. If you want to defer as much income as possible in a retirement plan, the Solo 401(k) is probably the best bet. If not, depending on your entity structure, a SEP IRA may be the way to go.
Founded in 1987, Darrow Wealth Management has a longstanding history of working to help business owners preserve and grow their wealth. Contact us today to learn more about our Wealth Management Program and for a free consultation with a financial advisor.