Retirement Planning For Small Business Owners and Freelancers: How Do You Choose Between a SEP IRA and a Solo 401(k)?

 If you’re a small business owner, planning for retirement can get a little confusing.

How do you know which retirement savings plan will work best for you? Specifically, how do you choose between the Simplified Employee Pension (SEP) IRA and a Solo 401(k)? 

Each has its own benefits and drawbacks, but after reading this post, you should be able to see which one will work the best for your circumstances. 

Here’s a walkthrough of how both types of accounts work and their pros and cons. 

What is a SEP IRA? 

A SEP IRA is an account that’s similar to a traditional IRA. 

Account owners can make tax-deductible contributions throughout the year, and the money in the account can grow tax-free. Once you do retire, you’ll be taxed on the qualified withdrawals you make. 

The SEP IRA is designed to allow small business owners, whether sole proprietors, partnerships, or corporations, to make contributions for themselves and their employees (if they have any). 

However, if you do have employees and you’re funding a SEP IRA for yourself, you are also required to contribute to the SEP IRA of every eligible employee. That contribution percentage must also match your own, so if you’re contributing 10 percent of your own compensation annually, you must also contribute 10 percent of each employee’s compensation annually. 

Here are a few of the pros and cons of a SEP IRA. 

  • Much higher contribution limits than for a traditional IRA. In 2021, you can contribute up to $58,000 per plan. For an IRA, you can only contribute up to $6,000. 
  • These accounts allow you to deduct all your employer contributions from your business taxes, which can help you save significantly on taxes.
  • You can still make contributions to a traditional or Roth IRA for yourself, in addition to your SEP IRA. However, you may not be able to deduct the full amount of those traditional or Roth IRA contributions. 
  • You must contribute to every eligible employee’s plan as well as your own, so the costs can become prohibitive. 
  • Employees aren’t allowed to open their own SEP IRAs, though they are allowed to open traditional or Roth IRAs. 
  • The same rules that apply to IRA accounts regarding withdrawals apply for SEP too: if you withdraw money before age 59.5, you pay regular income tax plus a 10 percent penalty for early withdrawal. You must also begin taking required minimum distributions, or RMDs, by the time you reach age 70.5

Takeaways: SEP IRAs are typically best for employers with a small number of employees. This prevents it from becoming too expensive, while also acting as a perk to attract new talent and retain current employees. 

What is a Solo 401(K)? 

Like a corporate 401(k), the solo 401(k) is a retirement account that allows you to contribute more per year than an IRA. You can fund it pre-tax, reduce your taxable income, and allow your investments to grow tax-free. When you make withdrawals during retirement, you’re taxed on those withdrawals. 

There’s also the option of opening a Roth solo 401(k), which does not reduce your taxable income as contributions are not tax-deductible. However, when you make withdrawals during retirement, you’re not taxed on that income. 

Solo 401(k)s are open only to self-employed individuals and their spouses (if the spouse is an employee in the business). You cannot open a solo 401(k) if you have additional employees. 

Here are some of the pros and cons of a solo 401(k).

  • Because you can contribute as both an employer and employee, there are much higher contribution limits than a traditional or Roth IRA. In 2021, you can contribute up to 58,000 for age 49 and under, and $64,000 for age 50 and over. 
  • If your spouse earns income from your business, you can double that contribution amount. 
  • You may require additional paperwork with a solo 401(k) come tax time, especially if your account is over $250,000.
  • Withdrawals during retirement are taxed as income, so if you think your income will be higher in retirement than it is today, a solo 401(k) may not make sense. 
  • You can’t open a solo 401(k) if you have any employees other than your spouse. 

Takeaways: Solo 401(k)s can work well for self-employed individuals who can make larger contributions than are allowed with a traditional or Roth IRA. 

If you have any additional employees, however, you cannot open this type of account. 

If you need help determining which kind of retirement account is right for you and your small business, contact AG FinTax today. 

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