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.
Photo credit Flickr
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?
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.
Thanks Roger, that makes sense. We may add employees at some point down the road so that will be something we have to look at then.
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.
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.
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.
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.
Max 2012 limits are $50,000, not $51,000.
Thanks for the note, can’t believe I didn’t catch that fixed the article.
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.
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.
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.
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.
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.
Steven thanks for your comment and I totally agree with you.
What do you recommend for a real estate agent to open?
Thanks
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.