One of the questions I often get from our small business owners, is “should I use a SEP IRA or a Solo 401(k)?” Let’s dig into these two investment options and discuss some of the pros and cons to both. They help minimize your personal and business taxes. We know we gotta get some money socked away for our retirement. So, in the debate: SEP IRA vs Solo 401(k), which is best for you?
A SEP IRA is really good for last year because we can establish this product all the way up to your filing date for your tax returns. Which if you filed an extension for last year, that’s all the way up to October of the current year. The cool thing about a SEP is if you have employees who have worked for you for less than three of the last five years, then you can discriminate against them. If you have a new business and you have employees where everyone has worked with you for less than three years, a SEP IRA may be good for you to use. That’s one reason you may consider that.
A few things to know about a SEP. A SEP limits your contribution amounts to 20%. So if you make a $100,000 in income then $20k is the max you can put in. If you make $50,000 in income, then $10k is the most you can contribute. A SEP IRA does not have ROTH provisions. Remember with a ROTH, you can put money in after taxes and it grows tax-free. It’s a cool feature but you can’t use it for a SEP. The other thing we can’t do with a SEP is to create loans from the account. So sometimes when working with our business owners, we need the provision to get money for tactical reasons. We just can’t do that with a SEP IRA.
In order to even be eligible for a Solo 401(k), you can’t have any employees. There is one exception, your spouse. They don’t count as an employee. Now, there are some technical parameters that you need to work out with your CFP® and your CPA with on that. However, for the most part, you and your spouse can make contributions to the Solo 401(k).
Now, remember that SEP contribution limit? You could only do 20%. It’s similar to the Solo 401(k), with one exception. Because it falls under the 401(k) guidelines, if you’re under the age of 50, you can make an $18,000 contribution this year. If you’re over the age of 50, you can contribute $24,000. PLUS, you make a 20% profit sharing contribution from the gross of your company’s profits. So back to our example, if you’re making $100k in profit you can put in $20,000 just like the SEP. Add that to your employee contribution of $18,000 or $24,000 and you’ve saved $38,000 or $44,000. However, with either plan, you cannot contribute more than $54,000 in 2017.
A really neat feature that I like with the Solo 401(k) is you can use a ROTH feature. Your employee contribution can go in as an after-tax contribution and it can grow tax-free from this point forward. So when it comes time for distribution, you can take the money out tax-free. That just isn’t available in a SEP.
Another feature of the Solo 401(k) is we can create a loan program. So if I’m working with a business owner and we’re going to make some tactical business decisions, I may want to use a loan from their retirement plan. Notice I said MAY want to use a loan. However, having that option with the Solo 401(k) gives me another strategic option for planning that the SEP IRA doesn’t allow.
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When it comes down to it, most of us make decisions based on cost. In the past, a Solo 401(k) was extremely expensive to set up. You had to pay a third party administrator to file the reports to the IRS. Now, since the Solo 401(k) is more popular, both plans are about equal in cost. So today there are pros for using a SEP. There are pros for using Solo 401(k) and there are cons for using them. Your particular situation will dictate which, the SEP IRA or Solo 401(k), is right for you. That’s why you need to meet with your CERTIFIED FINANCIAL PLANNER™ and your CPA. Between the two of these professionals, they can run the tax ramifications, look at all the pros and cons, and all the nuances to see what works best for you. Or you can always contact us so we can discuss your specific situation.