For other clients, whether they’ve transitioned into self-employed consultants or run a small business with their spouse, the burden is on them to set up and maintain their own retirement plans, and we help there too. Often times, these savings opportunities are overlooked. Many are surprised to find out they can increase their tax-deferred savings and reduce their tax liability beyond the standard IRA contributions limit of $6,000 ($7,000 if older than age 50).
For those in this camp, the two primary options are setting up a SEP IRA or a Solo 401(k), also referred to as an Individual 401k. But which one is right for you?
Both plans are easy to set up and operate, come with low administrative costs and allow for flexible annual contributions.
And each plan has a maximum contribution limit of $57,000 in 2020. As the owner, you can make contributions up to 25% of compensation or 20% of earned income. Earned income equals your net earning minus half of your self-employment taxes and 401(k) contributions.
Despite matching contribution limits, there are some nuanced differences between the two that make the Solo 401(k) the superior option.
The two key differences are the Solo 401(k) allows for an additional source of contributions and the “catch up” feature.
Contributions as Employee
Solo 401(k) allows owners to make contributions as both the employer and employee. You can contribute up to $19,500 in 2020 as an employee, and an additional $6,500 if you’re older than 50, and contributions can’t exceed your salary or earned income.
“Catch Up” Contributions
Solo 401(k) allows for an additional “catch up” contribution of $6,500 for those older than 50 years of age increasing the total limit to $63,500.
The bottom line is this: because of the ability to make a contribution as an employee and the “catch up” provision, the Solo 401(k) is usually the superior option.
Other Factors to Consider
Aggregation Rule for Backdoor Roth IRA Contributions
For anyone taking advantage of backdoor Roth IRA contributions, they’re familiar with the aggregation rule that applies. Read here for more about that, but essentially when converting assets to a Roth IRA, the IRS treats all existing IRAs as one. This eliminates the attractiveness of backdoor Roth contributions when there is existing IRAs with pre-tax dollars (i.e. Rollover IRA from previous employer).
For those that make an annual non-deductible IRA contribution and then convert that to a Roth IRA (i.e. Backdoor Roth IRA Contribution), funding a SEP IRA will create an issue and potentially make the Backdoor Roth IRA Contribution less appealing from a pure tax perspective.
When does a SEP-IRA make sense?
The deadlines to open a SEP-IRA and Solo 401(k) differ and that difference can matter in the first year of installment.
Solo 401(k)s must be set up by the end of the calendar year to be eligible for a contribution, despite the fact that you can actually contribute to the account (both employee and employee contributions) up until the date of filing, excluding extensions.
Importantly, a SEP-IRA can be opened and funded up to the date you file your taxes, including extensions, for the previous year. Technically, a SEP IRA can be opened and funded as late as October 15th for the previous year which is an obvious advantage.
Sometimes a SEP IRA makes sense in the first year because the decision to open and fund a retirement account isn’t made until the tax filing preparations are made the following year in spring or fall. At that point, the Solo 401(k) isn’t an option, despite the other advantages.
The key takeaways are this:
- Funding either a SEP IRA or Solo 401(k) is a great opportunity to increase retirement savings and reduce your tax liability beyond the standard IRA contribution limit
- Solo 401(k) allows for greater contribution amounts because of the opportunity to fund the employee portion and make “catch up” contributions if older than age 50
- If you’re taking advantage of Backdoor Roth IRA Contributions, funding a SEP IRA will most likely nullify that strategy, while a Solo 401(k) will not
- In the first year of adoption, a SEP IRA may be the only option because of the increased flexibility around opening deadlines.
If you have any questions on the strategies reviewed or are in interested in working with Cordant, please get in touch.