Maximizing Retirement Savings: Deciding Between SEP IRA and Solo 401(k)
Planning for a secure retirement is a paramount financial undertaking, especially for self-employed individuals and small business owners.
The solo 401k and SEP IRA are designed for self-employed individuals and small business owners for their retirement planning. They share similarities such as contribution limits, tax-free investment growth, and eligibility for various business types. However, the solo 401k provides greater tax benefits compared to the SEP IRA, though it comes with more specific qualification criteria. The choice between the two depends on your business structure and preferences.
Let's delve into the main distinctions:
Both the SEP IRA and solo 401k are accessible to individuals who are self-employed or own a business. The sole distinction in eligibility lies in the allowance of having employees for one plan and not the other.
- In the case of a solo 401k, you must not employ individuals who are at least 21 years old and have worked more than 500 hours per year for three consecutive 12-month spans (other than your spouse).
- Conversely, a SEP IRA permits the inclusion of employees. It also permits self-employed individuals without employees to establish a SEP IRA.
Both the SEP IRA and solo 401k share the same contribution limits, set at $61,000 in 2022 and increased to $66,000 in 2023. Nevertheless, only the solo 401k allows catch-up contributions.
- If you're aged 50 or above, the solo 401k enables an extra $6,500 contribution in 2022 and an additional $7,500 in 2023.
- The SEP IRA does not offer catch-up contributions. However, the crucial contrast in contributions lies not in the cap itself, but rather in the allowed contribution methods.
Getting the Most from Contributions
- Keep in mind that the contribution limit is the same for both: $61,000 in 2022.
- For both the SEP IRA and the solo 401k, employers can contribute up to 25% of their earnings. However, with the solo 401k, there's an extra benefit – you can also put in 100% of your income, up to $20,500, as an employee contribution.
Let's break down the calculations:
For SEP IRAs, contributions are solely based on employer compensation, allowing up to 25% of it to be contributed.To reach the $61,000 contribution cap, this implies requiring an income of $244,000 (25% of $244,000 equals $61,000).
On the other hand, a solo 401k also carries a $61,000 cap, but it allows a $20,500 contribution as an employee.By maximizing employee contributions, you'll have $40,500 remaining for the employer's side. To fully utilize this, your income should be $162,000 (25% of $162,000 equals $40,500). Hence, you'd need $244,000 for a SEP IRA but only $162,000 for a solo 401k to reach the maximum contributions.
This signifies a substantial $82,000 difference.
*These numbers are simplified and don't account for all tax nuances and deductions throughout the year. But the disparities don't stop there. The costs for SEP IRAs can escalate further if employees are part of the equation.
Learn more: SEP Plan FAQs & One-Participant 401(k) Plans
Matching Employee Contributions in SEP IRAs
Keep in mind that a SEP IRA solely relies on employer compensation and excludes contributions from employees themselves.
An associated rule with SEP IRAs involves matching contributions for employees.
When you contribute to your SEP IRA and have employees within your business, you're obligated to match the same percentage for your employees' SEP IRAs.For instance, if you opt for a 25% contribution of your compensation into your SEP IRA, you must also contribute 25% of each individual employee's compensation into their respective SEP IRAs. If your workforce is substantial, this can become costly, potentially making a SEP IRA less advantageous.
NOTE: The matching contribution requirement applies only to employees who are at least 21 years old, have worked for you for three out of the past five years, and earned a minimum of $650 in 2022 or $750 in 2023.
Roth Option Availability
Among retirement accounts, both the SEP IRA and solo 401k allow for substantial contributions. But a major difference lies in having a Roth choice, which is only found in the solo 401k, not in the SEP IRA. While the SEP IRA only lets you contribute to a pre-tax account, the solo 401k gives you the Roth option.
Important Note: Remember, not all providers of solo 401k plans offer the Roth feature. You can compare different providers that offer Roth solo 401k plans to find the best fit.
How the Roth Option Works:
In a solo 401k, contributions come from both the employer and the employee. Employer contributions are always pre-tax. But as an employee, you can decide whether to put your money into a Roth account or a pre-tax one.
The Roth solo 401k operates like a Roth IRA: You contribute with money that's already been taxed, and when you withdraw it in retirement, you don't pay taxes. What's special about the solo 401k is that its Roth part is three times larger than that of a Roth IRA. For comparison, a Roth IRA allows up to $6,000 ($7,000 if you're 50 or older) in 2022, and $6,500 ($7,500 if you're 50 or older) in 2023. However, the Roth solo 401k lets you contribute up to $20,500 ($27,000 if you're 50 or older) in 2022, and $22,500 ($30,000 if you're 50 or older) in 2023.
But, the SEP IRA doesn't offer a Roth option. Contributions are made with money that hasn't been taxed yet, which gives you a tax break in the current year. However, when you take out money in retirement, you'll owe taxes on it.
In a SEP IRA, your investment options are limited to conventional assets such as stocks, bonds, mutual funds, and ETFs. On the other hand, a solo 401k widens your investment horizon significantly, with minimal constraints. Alongside traditional investments, you gain the freedom to explore alternative assets including cryptocurrencies, NFTs, precious metals, and private equity.
If you wish to invest in alternative assets through a SEP IRA, the sole route is to establish a self-directed SEP IRA.
When it comes to taking out your money, the rules are the same for both the SEP IRA and solo 401k. You need to wait until you're at least 59½ years old to withdraw without extra charges. If you withdraw early, you'll face a 10% penalty fee plus regular income tax on what you take out.
However, there's a slight difference in how taxes work when you withdraw. The traditional solo 401k and SEP IRA are funded with money that hasn't been taxed yet. So, when you take money out, you'll pay income tax on it based on your tax rate at that time. But, if you have a Roth option in your solo 401k and you withdraw from it, you won't owe any taxes. This is because you already paid taxes on the money you put into the Roth account before contributing.
While a SEP IRA doesn't provide the option, a solo 401k offers the ability to take out a loan from your account. This loan allows you to borrow up to 50% of your plan's value or a maximum of $50,000. The interest rates can vary based on your plan provider, often tied to the current prime rate plus an additional one or two percent.
Although having this loan option might seem appealing, it's essential to understand its implications. It's not exactly a clear advantage due to the consequences that come with borrowing from your solo 401k. Essentially, you're taking money out of your retirement account and paying interest, which goes to the government. While the interest rate might not be overly high, the real impact lies in withdrawing money that could otherwise be growing tax-free through compounding in your account.
Nonetheless, the option is convenient. Solo 401k loans are easily accessible, involving a straightforward process without lengthy applications. They don't impact your credit score and can be used for any purpose you choose.
Which Option is Better?
In many retirement account comparisons, the answer is usually "it depends." However, in this case, if you're self-employed and don't have employees, the solo 401k typically emerges as the stronger choice.
1. Roth Option: The solo 401k offers a Roth option, whereas the SEP IRA doesn't.
2. Contribution Flexibility: Both have the same contribution cap of $61,000 in 2022 and $66,000 in 2023. But with a solo 401k, you can contribute as both the employer and the employee, while the SEP IRA only allows contributions from employer compensation. This means you can max out a solo 401k with a smaller amount compared to a SEP IRA.
3. Maximization Potential: With a SEP IRA, the $66,000 limit relies on up to 25% of your compensation. However, a solo 401k lets you put in up to $22,500 as an employee (100% of your compensation up to this amount) and the remaining portion, up to 25% of your compensation, as an employer contribution.
4. Investment Choices: A solo 401k permits a wide range of investments, including alternatives like cryptocurrencies and real estate. In contrast, a SEP IRA confines you to traditional assets.
5. Ease of Setup: Setting up a SEP IRA is generally simpler than a solo 401k. Not all brokers offer solo 401k plans, and those that do might not provide all the plan features, such as a Roth option.
In essence, if you're self-employed without employees and qualify for both options, the solo 401k tends to be the more favorable choice.
If you're ineligible for a solo 401k, a SEP IRA can be an excellent choice for business owners with minimal employees and substantial income. It offers a convenient method to swiftly establish retirement plans for your staff. The prospect of automatic contributions to their SEP IRA can also be appealing to potential employees.
Keep in mind that the SEP IRA comes with employee contribution matching rules. Whatever percentage you contribute to your SEP IRA, you must also contribute the same percentage to each employee's SEP IRA.
Can You Use Both a SEP IRA and Solo 401k?
Yes, it's possible.
Consider a scenario where you have two businesses: one with employees and one without. In this case, you can contribute to a SEP IRA for the business with employees, and simultaneously contribute to a solo 401k for the business without employees. However, the feasibility of this approach depends on the specifics of how your SEP IRA was established.
- SEP IRA Eligibility: Any self-employed individual or business owner, with or without employees, can contribute to a SEP IRA.
- Solo 401k Eligibility: To contribute to a solo 401k, you must not have employees working more than 1000 hours annually in your business (except your spouse).
- Contribution Limits: Both SEP IRA and solo 401k have a contribution cap of $61,000 in 2022 and $66,000 in 2023. Only the solo 401k includes catch-up contributions of $6,500 in 2022 and $7,500 in 2023 for individuals aged 50 or older.
- Contributions: SEP IRA contributions are made by employers only; employees cannot contribute. The contribution limit is up to 25% of your compensation (20% for solo practitioners or single-member LLCs) within the yearly cap.
- Solo 401k Contributions: Solo 401k permits contributions from both employers and employees. Employer contributions follow the same rules as SEP IRA, up to 25% of compensation (20% for solo practitioners or single-member LLCs). In addition, as an employee, you can contribute up to $20,500 ($27,000 if aged 50+) in 2022 and up to $22,500 ($30,000 if aged 50+) in 2023.
- Contribution Matching: SEP IRA necessitates contribution matching for employees. If you contribute to your SEP IRA, you must match the same percentage for each employee's SEP IRA.
- Roth Option: Solo 401k offers a Roth option allowing contributions up to $20,500 in 2022 ($27,000 if aged 50+). The SEP IRA lacks a Roth option.
- Investment Flexibility: Solo 401k provides flexibility, enabling investment in any asset class. SEP IRA restricts investments to traditional assets.
- Loan Option: Solo 401k permits loans of up to 50% of plan value, capped at $50,000. SEP IRA doesn't offer a loan option.
Choosing between a SEP IRA and a Solo 401(k) in 2023 requires a thorough analysis of your individual circumstances, financial goals, and preferences. Practical scenarios illustrate the advantages of each option based on different life stages and business situations.
Remember, both accounts offer significant tax advantages and opportunities for building a robust retirement fund. The SEP IRA is known for its simplicity, while the Solo 401(k) stands out with higher contribution limits, increased investment flexibility, and potential for Roth contributions. Engaging a financial advisor or tax professional is essential before making a decision. They possess the expertise to evaluate your unique circumstances, ensuring that you select the retirement savings vehicle that best aligns with your aspirations. Your choice should be geared towards optimizing your journey to a secure and fulfilling retirement.
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This post is just for informational purposes and is not meant to be legal, business, or tax advice. Regarding the matters discussed in this post, each individual should consult his or her own attorney, business advisor, or tax advisor. Vincere accepts no responsibility for actions taken in reliance on the information contained in this document.