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Solo 401(k) vs. SEP IRA: Which is Best for the Self-Employed?

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Christian Brim
Solo 401(k) vs. SEP IRA

You have successfully survived the start up of your business, and you're now making some money.   You know what that means?  Taxes!  One of the best tax strategies for entrepreneurs is funding a retirement plan.  Let's look at two popular options, the Solo 401(k) and the SEP IRA

SEP IRA

SEP IRA stands for Self Employed Pension Individual Retirement Arrangement.  For businesses that file as a Sole Proprietor (Schedule C), an owner can contribute 20% of their net income (subject to self employment tax) up to $58,000 (2021).  The dollar limit is adjusted annually to keep pace with inflation.  For other business entity types (S-Corporations), the contribution limit is 25% of wages up to $58,000 (2021).

Pros:

  • No business size limit
  • No Filing requirements for the plan
  • No required contributions
  • Can exclude employees under 21 or paid less than $650(2021) in a year
  • Can exclude union employees
  • Can exclude employees who haven't worked in at least three of the last five years

Cons:

Solo 401(k) aka Individual 401(k)

Although technically a Solo is a 401(k) there are limitations compared to a "regular" 401(k).  The primary being that you can only have yourself and your spouse as an employees.  If you have any other employees, you must follow the rest of the rules for a 401(k).  You and your spouse can contribute two ways in a 401(k), as an employee and as an employer.  As an employee, you can contribute 100% of your W-2 wage up to $19,500 (2021), $26,000 (2021) if you are 50 or over.

Pros:

  • No filing requirement for plans with less than $250k (form 5305-EZ for plans in excess of $250k)
  • Salary deferral
  • Employee Loan Option
  • ROTH Option

Cons:

  • Filing requirement when assets exceed $250,000.
Retirement Plan Guide-Download Now

Comparison Example 1

Let's assume you have no employees other than yourself, and you have an S-Corporation.  You take a wage of $50,000 each year and have another $50,000 in profit after your salary.  Here is what you could contribute to each:

SEP IRA

25% of your $50,000 W-2 Wages = $12,500

Solo 401 (k)

100% of your W-2 Wages up to limit = $19,500

25% of your W-2 Wages as employer = $12,500

Total contribution = $32,000

Comparison Example 2

Now let's assume that you are sole proprietor (Schedule C) and you make the same $100,000 as above.  Here is that the contributions would look like:

SEP IRA

20% of your $100,000 income subject to self employment tax = $20,000

Solo 401 (k)

100% of your W-2 Wages up to limit = $19,500

25% of your W-2 Wages as employer = $12,500

Total contribution = $32,000

If you would like to discuss retirement plan tax savings options for your business, drop us a line.  We are happy to be your Strategic Financial Partner! 


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