Which is Better? A SEP IRA or Solo 401(k) for My Side Business
November 13, 2019 | Stanley K. Himeno-Okamoto, CFP®, CFA
I have a full-time job, but I also consult for other companies or freelance for extra income. I want to use the extra income to save more for retirement; should I open a SEP IRA or a Solo 401(k)? Maximizing the use of your available tax-advantaged retirement options while maintaining a balance of current spending and taxable savings can be a powerful springboard for preparing for retirement. Not only do you get tax advantages from contributing to retirement accounts, there’s also an added disincentive to spend your retirement account funds early in the form of a 10% penalty tax for unqualified withdrawals.
Many consultants and self-employed people prefer the SEP IRA for its simplicity. If you have non-spouse employees, a SEP IRA is your only option (aside from setting up an ERISA plan for your company). However, for the sole proprietor, the Solo 401(k) has several features that give it flexibility and an advantage over the SEP IRA.
You can make pre-tax or ROTH (after-tax) contributions to a Solo 401(k), while the SEP IRA only allows pre-tax contributions. Consulting or single-owner business income can be very volatile year-over-year, and the Solo 401(k) provides the flexibility to defer taxes on contributions when income is high and to pay taxes now in exchange for tax-free withdrawals when income is low.
The Solo 401(k) has the same employee elective deferral rules as a Traditional 401(k) (up to $19,000 for 2019), along with total contribution limits (where you can make employer contributions up to 25% of compensation) up to $56,000 for 2019. The SEP IRA only allows employer contributions, limited by the same $56,000 and 25% of compensation, meaning that a Solo 401(k) has the potential of providing up to a $19,000/year head start over the SEP, depending on your income.
You can set up your Solo 401(k) to allow loans to be taken out without them being considered taxable distributions, while the SEP IRA doesn't allow loans.
So far it sounds like the Solo 401(k) is a clear winner for sole proprietors and consultants. More flexibility, a ROTH contribution option, potentially higher ability to make contributions, plan loans, etc. But there are a few catches.
The most important one is this: if you ever hire someone other than your spouse, you won't be able to continue funding a Solo 401(k). You'll need to start a different retirement plan (like a SEP IRA or Traditional 401(k)) and contribute accordingly. For most consultants this won't be a factor to consider, but be aware of this if your goal is to expand your business.
The next catch is that the $19,000 limit for employee deferrals applies across all plans you participate in. If you're already participating in a 401(k) plan at your full-time company, the amount you can contribute to a Solo 401(k) will be reduced.
Another catch is that once your Solo 401(k) value exceeds $250,000, you'll be required to file Form 5500 with the IRS annually, a requirement the SEP IRA doesn't face.
For me, I would choose a Solo 401(k) over a SEP IRA, but there is additional decision-making that must go into funding and maintaining a Solo 401(k). Do I make pre-tax or ROTH contributions? What's my employee deferral limit after I contribute to my full-time company's 401(k)? How much should I contribute as the employee vs. the employer? One of the biggest roadblocks to successful financial planning I see is decision overload. Don't kick your SEP IRA vs Solo 401(k) decision down the road or freeze up and avoid making a choice altogether - satisficing may be suboptimal, but it's better than putting off your retirement planning altogether.
Whether you're deciding whether a SEP IRA or Solo 401(k) is better for you, or you're trying to comprehensively plan for your future retirement, a financial planner can help you make informed decisions.
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