Written by Roger Wohlner for ThinkAdvisor.com
July 20th, 2021
You know the importance of having a retirement plan in place for your self-employed clients. Two key plans to consider are the SEP-IRA and the Solo 401(k). Determining the better choice for your client will depend upon their situation.
What Is a SEP-IRA?
SEP stands for simplified employee pension. A SEP-IRA is a type of traditional individual retirement account. SEP-IRA contributions are made only with employer contributions; no employee contributions are allowed.
If there are employees in the business, you must contribute the same percentage of compensation to their accounts as you do for your own. This can get expensive, and for that reason a SEP-IRA may not be the best retirement plan option for a business with employees. It is a solid option for those who are self-employed and don’t have employees in the business, or who only have a small number of employees for whom they are comfortable making contributions.
Benefits of a SEP-IRA
Contributions to a SEP-IRA can be made up to 25% of compensation, including self-employment income, up to a maximum of $58,000 for 2021. This percentage may be lower for a Schedule C taxpayer due to the way the calculation works, however. A SEP-IRA can be opened and funded up to the date that the business tax return is due, including extensions.
Downsides of a SEP-IRA
One potential downside is that Roth accounts are not available with a SEP-IRA. Since contributions are based on a percentage of income for the year, if your client has a low year in terms of compensation, their ability to contribute for the year will be limited. In addition, plan loans are not available with a SEP-IRA.
What Is a Solo 401(k)?
A Solo 401(k), also known as an individual 401(k), is a retirement plan that is available only to business owners, spouses involved in the business and business partners. Employee contributions are allowed at the same level as a 401(k) through an employer. For 2021, these levels are $19,500 plus a $6,500 catch-up contribution for those 50 or older.
Additionally, employer profit-sharing contributions of up to 25% of compensation can be made. This brings the maximum total contribution to $58,000; the maximum is $64,500 for those who are 50 or older for 2021.
Benefits of a Solo 401(k)
Depending upon the custodian chosen, a Roth option may be available for employee contributions, but not for employer profit-sharing contributions. Likewise, plan loans can be an option. The employee deferral option allows clients to contribute up to the maximum deferral amounts of $19,500 or $26,000 as long as their compensation is at least at these levels.
In comparing the two plans, if the maximum salary deferrals are made the Solo 401(k) can generally be maxed out in terms of total contributions at a lower compensation level than with a SEP-IRA.
Disadvantages of a Solo 401(k)
The plan must be opened by Dec. 31 in order to accept contributions for that year. Employee deferrals generally must be made by Dec. 31, though profit-sharing contributions can be made up to the date the business tax return is filed, including extensions.
A Solo 401(k) is not available to businesses that have employees other than the owner(s) or a spouse involved in the business.
Deciding Which Plan Is Better for Your Client
Here are some considerations in helping your small-business owning client decide between a SEP-IRA or a Solo 401(k) for their situation.
A Solo 401(k) might be the better choice if:
- The business doesn’t have employees other than the owner(s) and spouses involved in the business.
- Your client is willing and able to make employee deferral contributions.
- They want to be able to maximize their combined overall contributions from employee deferrals and employer contributions at a lower level of compensation than with a SEP-IRA.
- Your client’s compensation from the business is variable and they want to be able to contribute as much as possible each year.
- They want the flexibility of a Roth option and the ability to take a plan loan if needed.
A SEP-IRA might be the better option if:
- The client’s business has employees.
- The client wants the flexibility to open and fund the plan up until the date they file the business tax return, including extensions.
- Your client is looking for the option with the least amount of associated paperwork.
Can a Business Have Both Plans?
Technically, a business can have both plans as long as there are no employees. As a practical matter, this probably doesn’t make sense for a client. The overall contributions cannot exceed the annual limits established by the IRS, and there no doubling up between the two plans.
Having both types of plans might make sense in a situation where your client owns one business with employees and has another business with no employees. They could make SEP-IRA contributions for themselves and their employees for that business.
For example, they might also be involved in a consulting business on a solo basis or perhaps with their spouse. In this case, they could make the employee deferral contribution and some portion of the employer profit-sharing contribution depending upon their income from this business and the level of SEP-IRA contributions made for their other business.
Both types of plans will have the same restrictions on prohibited investments as an IRA and a 401(k), respectively. Both types of plans can generally be opened at a custodian offering self-directed retirement plans if your client wants to use their retirement account to invest in alternative assets such as investment real estate, crypto and others.
Your self-employed clients need your guidance in determining the best type of retirement plan for their situation. The SEP-IRA and the Solo 401(k) are two viable options to consider.