As a self-employed individual or successful business owner, you’ve got a lot on your plate. Thinking about the nuances of retirement accounts probably isn’t the first thing on your mind. Regardless of how well your business performs right now, a solid retirement plan is necessary to make sure the wealth that you generate remains protected throughout your lifetime and beyond. Utilizing a tax-qualified retirement account is a great way to maximize your wealth and ensure your hard work doesn’t go to waste. There are many retirement plan options available to 1099 employees and business owners, including solo 401(k) accounts and SEP IRAs. Here’s how to decide which wealth-building option is right for you.
Also known as an individual 401(k), a solo 401(k) is designed for businesses with only one employee, the business owner. The IRS calls it a one-participant 401(k) and only businesses without employees are eligible. If your spouse works for the business, they could also be covered by the plan without losing IRS eligibility.
- Roth accounts: As with other 401(k) plans, the solo 401(k) offers both traditional and Roth accounts. With a traditional account, contributions are made pre-tax and taxes are paid upon withdrawal. Roth 401(k)s, on the other hand, are funded with after-tax dollars but they grow tax-free. This gives you the flexibility to actively choose the contribution style that works best for your specific tax situation.
- Employee deferrals: Solo 401(k) plans also allow employee deferrals in addition to the employer contribution. This option is not available with SEP IRAs.
- Loan provisions: Another benefit of this plan is the ability to take loans against the account balance up to the lesser of 50% of the balance or $50,000.
- Higher contribution limits: Solo 401(k) plans have two types of contribution limits. First is the profit-sharing limit for employer contributions which is the lesser of up to 25% of business revenue or $61,000. (1) The next limit is the annual employee elective deferral limit, which is $20,500 for individuals under age 50, and $27,000 for those age 50 and older. (2) The combined limit for both employer and employee contributions is still $61,000 (or $67,000 if older than 50), but because there are two types of contributions permitted, most self-employed individuals will be able to contribute more and receive a larger tax break than if they used a SEP IRA.
- Strict reporting requirements: If your account balance exceeds $250,000, you will be required to file an annual return with the IRS. The return consists of Form 5500 and can be quite extensive. Even if you don’t have $250,000 in your account, you may be required to file.
- Only available for businesses with no employees: Individual 401(k)s are only available for businesses with no employees except the owner’s spouse. If you have plans to expand your business and hire additional employees, opening a solo 401(k) is probably not for you.
A Simplified Employee Pension (SEP) IRA functions similarly to a traditional IRA, except as the owner, you set up and contribute to accounts for both yourself and your employees.
- Tax-deductible contributions: Your contributions are tax-deductible up to 25% of all participants’ compensation, or up to 25% of net earnings if you’re self-employed. (3)
- Higher contribution limit: In 2022, the contribution limit for a SEP IRA is the lesser of 25% of an employee’s compensation or $61,000. (4) This limit is higher than the limit for tax-advantaged accounts like traditional and Roth IRAs, but as mentioned above, it is not as high as the limits for solo 401(k) plans.
- Easy setup & maintenance: SEP IRAs do not require the extensive reporting requirements required by other qualified retirement plans. You are also not responsible for the underlying investments in your employees’ accounts. As the employer, you simply choose the financial institution you want to work with and open the accounts. Beyond that, it is the employees’ responsibility to choose and manage their own investments. Additionally, many financial institutions offer SEP plans with little to no management fees, making this a very inexpensive and attractive option for small business owners.
- Contributions are discretionary: Contributions to these plans are flexible and discretionary, meaning you can adjust your contributions as your cash flow changes. This ensures that you never contribute more than you bring in.
- Strict eligibility requirements: According to the IRS, all employees must be allowed to participate in the SEP plan if they are age 21 or older, earned at least $650 in 2022, and worked for you for at least 3 of the last 5 years. (5) This can make SEP IRAs an inflexible option for small businesses that want to limit the number of employees in the plan.
- When you do contribute, you must contribute to everyone: In the years that you contribute to a SEP IRA, you are required to make equal contributions as a percentage of compensation to all eligible employees. For instance, if you contribute 20% of your income to your own SEP IRA, you must then contribute 20% of every employee’s income to their respective accounts. Because of this, SEP IRAs are generally recommended for self-employed individuals or small businesses with very few employees.
- No loan provisions, Roth accounts, catch-up contributions, or employee deferrals: Many of the benefits offered by solo 401(k)s are not available for SEP IRAs.
Which Choice Is Right for You?
Deciding between a solo 401(k) and a SEP IRA often comes down to how many employees you have and your specific tax situation. At Envision Wealth Planners, we can help decide which option makes sense for you and your business. To learn more about your options, schedule a no-obligation introductory phone call or reach out to me at firstname.lastname@example.org or 407.720.6535 today.
Sean Gerlin is founder, principal, and a financial planner at Envision Wealth Planners, an independent financial advisory firm founded on the core values of family, honesty, and a determination to be a master of the trade. With almost 10 years of experience, Sean specializes in serving affluent families and commercial real estate executives and brokers, providing comprehensive, customized financial guidance and services for their complex financial needs. Sean acts as a family CFO, managing and coordinating the many moving pieces of his clients’ financial lives. Sean is known for his commitment to building long-term relationships and paying personal attention to each client. He is passionate about helping his clients experience the relief that comes from having organized and well-planned strategies and portfolios, and he desires to help them by shouldering some of the financial burdens they face.
Sean has a bachelor’s degree from the University of Florida and holds the CERTIFIED FINANCIAL PLANNER™, Chartered Financial Consultant®, and Chartered Life Underwriter® certifications. When he’s not working, you can find him cooking, eating good food, traveling, coaching his son’s baseball team, or playing golf. He loves spending time with his wife, Nicole, and their two kids, Avery and Will, and entertaining friends in their beautiful backyard. To learn more about Sean, connect with him on LinkedIn.