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Self-employed designer contemplates retirement plan options such as solo 401(k)s and SEP IRAs

SEP IRAs and solo 401(k)s are tax-deferred retirement savings vehicles for small business owners. They’re similar to each other but with one big difference. With a solo 401(k), a self-employed business owner can make contributions as both the employee and the employer.  We’ll explain everything you need to know to make the call between a SEP IRA and solo 401(k). If you don’t know where to begin to set up the plan the best fits your needs, a financial advisor can help.

What Is a SEP IRA?

If you run your own business and have a small number of employees, you may be interested in a Simplified Employee Pension (SEP) plan or SEP IRA. It allows you to contribute toward your retirement savings while doing the same for your employees.

A SEP functions similarly to a traditional IRA. This means your contributions are tax deductible and your money grows tax-free. The IRS taxes your distributions when you make qualified withdrawals in retirement. However, you enjoy some perks you won’t get with a traditional IRA.

For starters, you may enjoy much larger contribution limits. You can contribute the lesser of the following in 2019:

  • 25% of your compensation (with a $280,000 ceiling for the calculation)
  • $56,000

Meanwhile, a traditional IRA permits contributions up to $6,000 or $7,000 if you’re at least age 50.

That said, if you contribute to a SEP IRA for yourself, the IRS requires that you also  contribute toward the SEP IRA of every eligible employee. What’s more, those employer contributions much match the percentage of compensation you contribute toward your own. So if you contribute 20% of your compensation toward your own SEP IRA, you must also contribute 20% of each eligible employee’s compensation to his or her individual plan.

Eligible employees, as far as the IRS is concerned, are those that meet the following criteria:

  • They’re at least 21 years old
  • They’ve worked for you during three of the last five years
  • They’ve earned at least $600 from you in the past year

How Does a SEP IRA Work?

A SEP IRA has many of the same features as an IRA. You can open one through most financial institutions or banks that offer traditional IRAs. Most providers offer access to an array of funds with which you can build your SEP IRA portfolio. You can construct one with various investment options including the following:

SEP IRA Pros and Cons

A SEP IRA can help the self-employed save for retirement

In addition to having high contribution limits, a SEP IRA allows you to deduct all your employer contributions when calculating your business taxes. Also, there is no rule  stopping you from making additional contributions to a traditional IRA or Roth IRA for  yourself, though the amount you can claim as tax-deductible may be limited.

As far as cons go, the SEP IRA has many of the same restrictions as IRAs. If you withdraw money from your account before turning 59.5 years old, the distribution would be taxed as ordinary income plus a 10% early withdrawal penalty. In addition, you must begin taking required minimum distributions (RMDs) when you turn 70.5. This ensures that the government starts receiving taxes on your savings.

Plus, the fact that you must contribute toward each employee’s plan can make this a particularly expensive choice. So a SEP IRA perhaps is best for small-business owners with a small pool of employees. Automatic contributions toward your employees’ plans can be a major selling point to attract the right talent. Employees can’t contribute to their own SEP IRAs in most cases. But they’re also allowed to open their own traditional or Roth IRAs. But if this proves to be more expensive than beneficial, you can set up a solo or individual 401(k) plan for your business.

What Is a Solo 401(k)?

A solo 401(k) or sole-participant 401(k) is a retirement plan designed for the self-employed who can sock away more than traditional or Roth IRA limits. You can open one only if you and your spouse are the only employees in your business.

A solo 401(k) functions much like its corporate counterpart. If you have a solo 401(k), you fund it on a pre-tax basis and your investments grow tax-free. Or you can opt for the Roth solo 401(k). You fund it with after-tax dollars, so it won’t reduce your taxable income. But your earnings are tax-free when you make qualified withdrawals.

In 2019, as an employee, you can contribute up to $19,000 to your solo 401(k), and an additional $6,000 if you are at least age 50. These are the same limits corporate 401(k) plans have.

As with a corporate 401(k), you, as an employer, can also contribute to your solo 401(k). This is to tune of up to 25% of your compensation. The IRS defines this as your net earnings from self employment minus one half of your self employment tax and the contributions you made to your plan as an employee. However, only up to $280,000 worth of compensation can get calculated into your employer contribution limit.

That said, total contributions (employer and employee, combined) to your solo 401(k) can’t exceed $56,000, or $62,000 if you’re at least 50 years old in 2019.

To calculate your contribution limits and allowable tax deductions accurately, you can use the worksheet on IRS Publication 560. Look under “Retirement Plans for Small Businesses.”

Pros and Cons of a Solo 401(k)

A solo 401(k) is a great option for a self-employed individual with no employees who can afford to save more than $6,000 a year, the traditional IRA limit. Not only can you make bigger contributions as an employee, but you can also make contributions as an employer.

What’s more, you can double that amount if your spouse also earns income from your business. The only con to a solo 401(k) is that it may involve a little more paperwork, so it’s only worth setting up if you’re looking to make large contributions to it.

How Do I Open a Solo 401(k)?

You can open a solo 401(k) through most financial institutions and online brokers. You just need your employer identification number to apply. You’d most likely need to sign a plan adoption agreement and fill out an application.

Moving forward, a solo 401(k) works like most retirement plans. You can build a diversified portfolio with a variety of funds like stocks, bonds and mutual funds. But you must fill out IRS form 5500-SF if your plan has more than $250,000.

The Takeaway: Solo 401(k) vs. SEP IRA

sep ira vs. 401k

If you’re deciding between a solo 401(k) and a SEP IRA, and you have employees, the choice is easy: SEP IRA. You can’t open a solo 401(k) plan if you have an employee other than your spouse.

But if you’re self-employed with no employees, the choice depends on how much you plan to save. If you can’t put away more than $6,000, you should go with the SEP IRA until you can afford to save more. If you don’t want to defer taxes, you may want to open a solo Roth 401(k) or a Roth IRA, depending on how much you can save.

Retirement Planning Tips

  • If you’re in business for yourself, a financial advisor can help you with retirement planning. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
  • It’s natural for entrepreneurs to want to put all their net earnings back into their business. But you should put at least some of it in retirement savings. You can start small with a traditional IRA or a Roth IRA. To help you make the right decision, we published studies on the best IRAs and the best Roth IRAs.

Photo credit: ©iStock.com/StockRocket,/©iStock.com/designer491, ©iStock.com/Nuthawut Somsuk

Javier Simon, CEPF® Javier Simon is a banking, investing and retirement expert for SmartAsset. The personal finance writer's work has been featured in Investopedia, PLANADVISER and iGrad. Javier is a member of the Society for Advancing Business Editing and Writing. He has a degree in journalism from SUNY Plattsburgh. Javier is passionate about helping others beyond their personal finances. He has volunteered and raised funds for charities including Fight Cancer Together, Children's Miracle Network Hospitals and the National Center for Missing and Exploited Children.
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