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Small Business Retirement Plans – SEP-IRA vs. Solo 401(k)

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Lincoln-Herndon Law Offices, Springfield

This time of year many small business owners are looking for additional tax deductions.  One of the best deductions is funding a retirement plan.  Beyond any tax deduction you are saving for your retirement.  As a fellow small business person, I know how hard you work.  You deserve a comfortable retirement.  Two popular plans are the SEP-IRA and Solo 401(k).

A comparison of the main features of the two plans

SEP-IRA Solo 401(k)
Who can contribute? Employer contributions only Employer contributions and employee deferrals
Employer contribution limits For 2013, up to 25% of the participant’s compensation or $51,000 ($50,000 for 2012), whichever is less.Contributions are deductible as a business expense and are not required every year. For 2013, employer plus employee contribution limit is $51,000 ($56,500 if the employee is age 50 or older).  For 2012 the limits are $50,000 and $55,500.Contributions are deductible as a business expense and are not required every year.
Employee contribution limits Technically there are no employee contribution limits, but employees can contribute to an IRA (Traditional, Roth, or Non-Deductible based upon their individual circumstances). $17,000 for 2012 and $17,500 for 2013.  An additional $5,500 for participants 50 and over.  In no case can this exceed 100% of compensation.
Eligibility Typically, employees must be allowed to participate if they are over age 21, earn at least $550 annually, and have worked for the same employer in at least three of the past five years.  Check with your custodian for specific eligibility requirements. No age or income restrictions, generally.

 

Note the Solo 401(k) is also referred to as an Individual 401(k).

A few points to consider 

  • While a SEP-IRA can be used with employees in reality this can become an expensive proposition as you will need to contribute the same percentage for your employees as you defer for yourself.  I generally consider this a plan for the self-employed.
  • Both plans allow for contributions up your tax filing date, including extensions for the prior tax year.  The Solo 401(k) plan must be established by the end of the calendar year.
  • Note that the SEP-IRA contribution is calculated as a percentage of compensation.  If your compensation is variable so will the amount that you can contribute to plan year-to year.  Even if you have the cash to do so, your contribution will be limited by your income for a given year. 
  • By contrast you can defer the lesser of $17,500 ($23,000 if 50 or over) or 100% of your income for 2013 into a Solo 401(k) plus the profit sharing contribution.  This might be the better alternative for those with plenty of cash and a variable income.
  • Loans are available from Solo 401(k)s, but not with SEP IRAs.
  • A Roth feature is available for a Solo 401(k) if allowed by your plan document. There is no Roth feature for a SEP IRA.
  • Both plans require minimal administrative work, though once the balance in your Solo 401(k) account tops $250,000, the level of annual government paperwork increases a bit.
  • Both plans can be opened at custodians such as Charles Schwab, Fidelity, Vanguard, T. Rowe Price, and others. For the Solo 401(k) you will generally use a prototype plan. If you want to contribute to a Roth account, for example, ensure that this is possible through the custodian you choose.
  • Investment options for both plans generally run the full gamut of typical investment options available at your custodian such as mutual funds, individual stocks, ETFs, bonds, closed-end funds, etc. There are some statutory restrictions so check with your custodian.

Both plans can offer a great way for you to save for retirement and to realize some tax savings in the process.  Whether you go this route or with some other option I urge to start saving for your retirement today 

Please feel free to contact me with your financial planning and investing questions or to discuss your retirement plan options.  

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Comments

  1. Good comparison of the two Roger! This is something we’re going to have to be dealing with ourselves now that we run our own business. We actually have some cash on the side waiting to fund an IRA depending on what our taxes will look like. One thing I was not aware of was the eligibility requirements behind the SEP. So, if I am reading it correctly, if you’re business is less than three years old then you would not qualify to have a SEP…is that correct? Or, since it is our business would we (generally) be good to go?

    • Roger Wohlner says:

      Thanks for the comment John. As far as SEP eligibility what I listed was the longest that you can typically require until an employee is eligible. In the case of you and your wife you would be good to go, but consult with the custodian you decide upon (Vanguard, Fidelity, Schwab, etc.) about any rules along these lines. They generally have folks who are knowledgeable on these plans. The bigger point is that for a firm with employees a SEP can get quite expensive quickly, I generally have only used it for self-employed clients, including spouses working together.

  2. I never really paid attention to SEP IRAs as they never applied to me, however as I look more and more into becoming self employed I see that I need to get spun up on them fast. Thank you for sharing.

    • Roger Wohlner says:

      Marvin thanks for the comment. Depending upon your situation both the SEP-IRA and Solo 401(k) might be worth a look. Feel free to contact me directly with any questions.

  3. Lisa says:

    In light of the performance of traditional investments, a Solo-401(k) may be preferable. You mentioned investments are governed by the custodian, however, the trustee may be able to invest in non-qualified assets.

    • Roger Wohlner says:

      Lisa thanks for your comment. By non-qualified assets I’m assuming you mean things such as a business or real estate? If that is case my comment is that just because someone is able to doesn’t mean they should.

  4. DC says:

    Max 2012 limits are $50,000, not $51,000.

  5. Jim Lawson says:

    Roger, you really need to add traditional defined benefit plans to your mix. A 55 year old business owner can contribute 100% of his pay, or more into a traditional plan – a much more lucrative alternative to any type of IRA or 401 (k) plan.

    • Roger Wohlner says:

      Jim thanks for the note. While I agree that DB plans (including cash balance) can be an excellent option, the intent of this article was ONLY to compare and contrast the SEP and Solo 401(k). An article with a broader scope dealing with the range of alternatives would need to include DBs as you point out.

  6. Good summary of the two! Being an employee, I’ve had very little experience with either of these. So its good to see comparisons like this and understand the differences between the them. Its good to know that if I was self-employed I would have these to use at my disposal.

    • Roger Wohlner says:

      Thanks for your comment. Depending upon one’s situation, both plans offer some good options and have some pros and cons. At the end of the day, I always encourage anyone who is self-employed to start saving for their retirement in either plan or one of the other options available as soon as possible. Business owners work hard and deserve the best retirement possible.

  7. Very comprehensive guide for these two plans. These are great options for any small business, but as you say they make the most sense where there are no other employees or there are only a few who make low wages. Also remember that part time employees who work less than a 1000 hours may be excluded. Anyone considering such plans should get with their tax attorney or tax accountant to explore which one is best for their particular situation.

  8. philip says:

    What do you recommend for a real estate agent to open?
    Thanks

    • Roger Wohlner says:

      Philip thanks for your comment. Without knowing the particulars of your situation its hard to provide a definitive answer. The SEP-IRA provides the most flexibility in terms of being able to open one right up until you file your taxes for the prior year and in terms of minimal paperwork. While the contribution limits are high, if you have a down year income wise but still have the cash to contribute you will be limited in terms of the level of your income. For this reason the Solo 401(k) might be a good choice. Both are generally easy to open at places like Fidelity, Schwab, TD, Vanguard, etc. If you want to contact me directly (via the contact page of the blog) I’d be glad to discuss your situation in a bit more detail.

  9. Tina C says:

    Great article! I have been self-employed for 17 years and always contribute the max to a SEP, but as I now see retirement (hopefully) 10 years away and can sock away more of my income, I’m wondering if a 401K-solo is a better option. I was initially considering keeping the SEP and also opening/contributing to a Roth IRA, which I was told I could do (I am over 50). Your thoughts?

    • Roger Wohlner says:

      Tina thank you for your comment. A lot depends upon your situation, the consistency of your income stream and other factors. I’d be glad to speak with you offline please feel free to contact me

  10. Mark says:

    If you have a solo 401k, can you transfer from it to a SEP IRA any time you want?
    Can you contribute to both a solo 401k and a SEP IRA in the same year?
    If you have a solo 401k, are you required to contribute to it at all, or can you choose a SEP IRA in any given year?

    • Roger Wohlner says:

      Mark thanks for your comment. In answer to your first question, the answer is generally yes. To the second question again I believe the answer is yes, but remember the contribution limits for each type of plan. There is a maximum contribution that you will be allowed and this is a combined limit. You are never required to contribute to either your SEP-IRA or your Solo 401(k). My question to you is why would you want both? Frankly in many cases the Solo 401(k) will provide the most contribution flexibility, but each situation is different.

      • Mark says:

        A SEP IRA is what I know and understand, and I like the flexibility. I can easily move it from firm to firm, I can have multiple IRA’s at different firms, I can easily do a Roth conversion, etc. I do like the higher contribution limits of the 401k. I spoke to one firm offering the 401k, and they told me about all the limitations, so now I am trying to determine if these are limitations just there, or if these are IRS limitations. They told me I cannot move funds from the 401k to a SEP without a “qualifying event”, like death, disability, closing the 401k, etc. And according to them, I need a legitimate business reason to close the 401k, and if I close it after the first year, the IRS will ask why. They also said I cannot have multiple 401k’s at different firms, and that if I have a 401k, I am expected to contribute to it, rather than a SEP. They said I cannot split my allowable contribution between the two, and each year I must choose the SEP or the 401k. I’d prefer to use the 401k just to contribute the amount not allowed in a SEP and continue building up my SEP, and if possible transfer it out from the 401k to the SEP as quickly as possible.

        • Roger Wohlner says:

          My reaction to your comment is that you are making this way too complicated. IRA’s at multiple firms, moving from firm to firm? I don’t get it, seems like the focus is on everything except planning your investments and your retirement needs. Just my observations in reaction to your comments.

  11. chaz says:

    So I have decided to open a solo 401k plan to invest the extra income. I went online to IRS website and got an EIN specifically for the solo 401K but then when I later spoke with another IRS agent, he stated that I needed another EIN # as a sole proprietor and went ahead to issue me another. So I now have 2 EIN #.

    So please which do I use for my solo 401K application? And does having two EIN # complicate my tax filing issue? Thanks

    • Roger Wohlner says:

      Chaz thanks for your note and kudos on the decision to open a Solo 401(k). Glad to try to answer your questions, however please contact me directly via the contact page of this blog hard to address in this forum. Thank you.

  12. Leslie says:

    Great article. I am newly self employed and have an S corp. I have 2 401Ks from previous emplyers. One from when I was a kid in college that I never moved or did anything with. The second from my most recent employer. I am trying to decide on the benefits of doing a solo 401K versus a SEP. I guess I can rollover the previoous 2 plans into a the new plans whichever one i decide on. If i decided I didn’t want the 401K can I change over to a SEP? I am single, no dependents. I want to maximize any tax benefits etc.

    • Roger Wohlner says:

      Thanks Leslie, glad you found it helpful. Please feel free to contact me via the contact form on the blog if you have some specific questions that you would like to discuss.

  13. Jim Bond says:

    Roger, in response to Mark about having both a SEP and a solo 401K you wonder why he would want both. It seems to me that because you can contribute the maximum percentage of your compensation to one plan without hitting the dollar max, you’d want to contribute to the other plan to the point you reach that dollar max, and your maximum deduction.

    • Roger Wohlner says:

      Jim thanks for your comment. My comment to Mark was more about his making this way more complicated that I think this needs to be. I’ve never actually seen anything that says you can’t contribute to both and in certain situations it might make sense to use both to contribute the max dollar amount. My only caution would be to say that one should be sure to work with a financial or tax advisor who understands the overall dollar and percentage limits on these plans.

  14. Dave says:

    If I have an S-corp consulting company and I’m the only employee but have a unusually great year and want to minimize my taxable income, can I hire my spouse and pay her $208K in W2 wages in addition to my own $208K W2 wages and double up on the maximimum SEP contribution of $52K per person for a total tax deductible contribution of $104K? Or is it $52K max SEP contribution per couple/household? I’m considering my options that also include a combo of 401K, profit sharing, and defined benefits plan which commits me to future contributions even if my future years aren’t quite so great from a cash flow standpoint (which is my main concern)

    • Roger Wohlner says:

      Dave thanks for your comment. First let me say that I do not hold myself out as any sort of tax expert. That said the SEP contribution limits are per person not per couple. Likewise with a solo 401(k) if that is under consideration. I would guess at some point, if asked, you would need to document that your wife is actually an employee of the business. I’d be glad to discuss your situation in more detail offline if you’d like, please feel free to contact me via the contact form on this blog.

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