Objective information about financial planning, investments, and retirement plans

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

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One of the best tax deductions for a small business owner is funding a retirement plan.  Beyond any tax deduction you are saving for your own retirement.  As a fellow small business person, I know how hard you work.  You deserve a comfortable retirement.  If you don’t plan for your own retirement who will? Two popular small business retirement plans are the SEP-IRA and Solo 401(k).

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

SEP-IRA vs. Solo 401(k)

SEP-IRA Solo 401(k)
Who can contribute? Employer contributions only. Employer contributions and employee deferrals.
Employer contribution limits The maximum for 2017 is $54,000 and increases to $55,000 for 2018. Contributions are deductible as a business expense and are not required every year. For 2017, employer plus employee combined contribution limit is a maximum of 25% of compensation up to the maximums are $54,000 and $60,000, respectively. For 2018 these limits increase to $55,000 and $61,000. Employer contributions are deductible as a business expense and are not required every year.
Employee contribution limits A SEP-IRA only allows employer contributions. Employees can contribute to an IRA (Traditional, Roth, or Non-Deductible based upon their individual circumstances). $18,000 for 2017. An additional $6,000 for participants 50 and over. In no case can this exceed 100% of their compensation. The limits for 2018 increase to $18,500 and $24,500 respectively.
Eligibility Typically, employees must be allowed to participate if they are over age 21, earn at least $600 annually, and have worked for the same employer in at least three of the past five years. No age or income restrictions. Business owners, partners and spouses working in the business. Common-law employees are not eligible.

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

  • 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. Consult with your tax professional to determine when your employee contributions must be made. The Solo 401(k) plan must be established by the end of the calendar year.
  • The SEP-IRA contribution is calculated as a percentage of compensation.  If your compensation is variable the amount that you can contribute year-to year will vary as well. 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 $18,000 ($24,000 if 50 or over) or 100% of your income for 2017 and $18,500/$24,500 for 2018 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 possible from Solo 401(k)s, but not with SEP-IRAs.
  • 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 

Approaching retirement and want another opinion on where you stand? Not sure if you are invested properly for your situation? Check out my Financial Review/Second Opinion for Individuals service.

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Roth 401(k) vs. Traditional 401(k)

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I’m excited to publish the first guest post on this blog.  Joe is a personal financial blogger posting at his site www.joetaxpayer.com.  Joe was kind enough to share his thoughts on choosing between a Traditional 401(k) and a Roth 401(k) if your plan allows for this option.  Check out Joe’s Plutus Award winning blog for more excellent insights.

Today, let’s look at the differences between the Traditional 401(k) and the Roth 401(k). Similar to the Traditional IRA, the Traditional 401(k) permits you to make deposits to your account, pre-tax, and then, at retirement, withdraw money and pay tax upon withdrawal. The Roth 401(k) is similar to the Roth IRA, in that you make deposits with post-tax money, but will be able to withdraw both deposits and growth with no further taxes due after you retire.

Tax Planning Considerations

Seems pretty simple, no? Not so fast. It’s easy enough to look at your current marginal rate, which is the tax you pay on that last dollar of income. When you look at your total tax bill over your total income, you get an average rate which isn’t as useful for this analysis. The tougher thing is to know what your rate will be in retirement. Do you have a traditional pension from your current or former employer? How much have you already saved in pre-tax 401(k) accounts or Traditional IRAs? These are some of the factors you’ll need to consider when starting to think about whether to choose the Roth 401(k).

Let’s take a closer look at the numbers. In 2012 a couple, married filing joint, will have a standard deduction of $11,900 along with two exemptions of $3,800 each for a total $19,500 that comes off the top when calculating their taxable income. If they itemize, they may have a Schedule A showing higher than $11,900, but that’s the minimum this year. It then takes $70,700 of taxable income to hit the top of the 15% bracket (see chart above). Just over $90,000 per year gross income and still in the 15% bracket. If you are comfortable taking 4% per year withdrawal, it would take $2,250,000 in pretax accounts to fund the $90,000 per year withdrawal.

Saving your way to a higher bracket isn’t easy, nor is it so common. It can easily occur, however, with an employer whose pension is generous, or for those whose 401(k) is heavily invested in investments that have done very well. In such situations, using the Roth 401(k), funded with after tax dollars, will keep your pretax savings from snowballing out of control, potentially putting you in a higher bracket come withdrawal time. Even if you choose the Roth, any employer deposit remains on the traditional, pretax side.

Other Considerations

Last, it’s not just about now vs. retirement. When you change jobs you should consider rolling your 401(k) money into an IRA. During the course of your life, in any year your income is below average you should take the opportunity to convert a bit of your Traditional IRA to a Roth IRA, reporting the conversion as income, but at a lower than average bracket.

As you approach retirement, the big picture becomes more clear, and the last years before you retire can help you balance your accounts between the Traditional 401(k)/IRA and Roth flavors of these accounts. For the working couple where one spouse has retired earlier than the other, the years where a single check is coming in is the ideal time to deposit to the Roth and to convert a bit from the Traditional accounts before the larger withdrawal start to come during full retirement living.

Check out guest author Joe’s blog www.joetaxpayer.com for more great articles like this one.

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