Solo 401K vs SEP IRA: Which one should you choose?

Roshani Pandey is a financial advisor and founder of True Root Financial. True Root Financial is located in San Francisco, CA and serves clients across the globe.

If you’re a self-employed individual, you must consider a SEP IRA and a solo 401K, not only to save for retirement but also to save a lot in taxes. So, which vehicle should you choose between a SEP IRA and a solo 401K? In general, if you are a self-employed individual, a solo 401K is a much better choice than a SEP IRA. However, there are some cases in which a SEP IRA could be better for you.

First, let’s clarify who is considered self-employed

A self-employed individual is anyone who works for themselves or as a contractor. If you work as a contractor and the firm you work for does not issue you a W-2, you are a self-employed individual. This may include the following professions:

• Physicians
• Real estate agent
• Business coach
• Consultant
• Small business owner

Watch our video below on Solo 401K vs. SEP IRA

Choosing a Solo 401(k)

The solo 401(k) is a one-participant 401(k), which is a lot like a traditional 401(k)

To describe these plans, the business owner acts as both the employer and employee. Hence, the owner can contribute both as an employer and an employee:

1) Employee contributions – As an employee of your own firm, you can contribute up to 100% of of your earned income for a maximum amount of $20,500 in 2022 or $27,000 in 2022 for those age 50 and older

2) Employer contributions –

– As the employer, you can contribute additional profit-sharing funds of up to 25% of your net income—i.e., your net profit less half your self-employment tax and the plan contributions you made for yourself.

– When calculating your contribution, you can calculate it on a maximum compensation level of $305,000 this year.

Total contributions cannot exceed $61,000 this year. If your spouse works with you in the business, they can also contribute.

Why is a solo 401 K superior to a SEP IRA?

When comparing a solo 401K vs a SEP IRA, a solo 401 K has many advantages:

• You can contribute a lot more to retirement plan and also save a lot more in taxes than with a SEP IRA.
• A solo 401K allows you to contribute to a Roth 401 k, which is not possible with a SEP IRA. The Roth option can be really valuable, especially in years where your income is lower and with a ROTH IRA, you can save a lot more in a tax-efficient way.
• With a solo 401k, you can take a loan of up to $50,000 which is not available with a SEP IRA

Choosing a SEP-IRA Plan

Simplified Employee Pension (SEP) is a simple way to save for retirement in a tax-advantaged way for anyone that is self-employed or has a small business with a few employees.

Contributions an employer can make to an employee’s SEP-IRA cannot exceed the lesser of:

• 25% of the employee’s compensation, or
• $61,000 for 2022 ($58,000 for 2021 and $57,000 for 2020)

One key feature of a SEP IRA is that only the employer contributes to the SEP IRA. So, these plans are generally best for self-employed individuals or a small company with a few employees. The good thing is that you’re not required to make a contribution every year and can skip contributing.

When is a SEP IRA a better choice?

Even though a Solo 401K is a better choice for most self-employed individuals, there are some instances where a SEP IRA is advisable:

• A SEP IRA is more flexible and easier to open than a Solo 401K. While the latter needs to be opened by December 31st of any given year in order to contribute for that year, a SEP IRA, on the other hand can be opened right until you file taxes
• So you can literally open a SEP IRA on April, 14 and contribute to it before the April, 15 deadline, when you file your taxes. So, if you’re past the deadline to open a solo 401K, you can do a SEP IRA for that year and then roll over the proceeds to a solo 401K.
• The other reason to go with a SEP IRA instead of a solo 401K would be if you plan to hire employees in the future besides just you and your spouse. A solo 401K is only meant for a one-person shop. So if you plan to have more employees consider SEP IRA and other retirement plans to figure out what might be right for your business

Next steps for you

Evaluate the benefits of a solo 401 K vs a SEP IRA for you and open a retirement account today. This can be a great way to save for your nest egg and shelter significant earnings from taxes. If your income is a lot higher, add a profit-sharing contribution and a cash balance plan. These plans can provide a significant tax break for a small business owner.

If you would like to talk to us about setting up a SEP IRA or a solo 401K, please book an introductory call below:

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