Two of the best options for the self-employed are the SEP-IRA and the Solo 401(k). Both options offer current tax deductions and the ability to grow retirement savings on a tax-deferred basis until retirement.
SEP stands for Simplified Employee Pension. A SEP-IRA is a type of IRA with higher contribution limits. All contributions are made by the employer, no employee salary deferrals are allowed.
The maximum contribution is the lesser of 25% of compensation or $57,000 for 2020. This includes salary or self-employment income if the saver is a Schedule C taxpayer. In reality, Schedule C taxpayers may be limited to 20% of net income due to the way the calculation works.
With a SEP-IRA employees of the company are eligible, though this can get expensive as the business owner must provide each employee with the same percentage contribution as he or she gives to themselves. These plans generally work best for those who are self-employed with no employees or perhaps a business partner or a family member who is part of the business.
A SEP-IRA can be started up to the date you client files their tax return, including extensions, for the prior year. For example, a client who is a Schedule C taxpayer can open and fund their SEP-IRA up until Oct. 15 of 2020 and still include the contribution as part of their 2019 return if they file an extension for the year.
Account holders cannot take a loan from their SEP-IRA and there is not a Roth version of the SEP-IRA that is available.
Participation in a solo 401(k) is limited to the business owner, a spouse who is active in the business and any business partners. Like a 401(k) for a company, participants can contribute from their salary or self-employment income up to the limits for a 401(k) plan in effect for that year.
Additionally, the employer can make profit sharing contributions of up to 25% of compensation, for 2020 this combined limit is $57,000 or $63,500 for those who are 50 or over. These contributions are deductible business expenses.
Unlike a SEP-IRA, a Roth solo 401(k) can be opened. Loans can be taken from a Solo 401(k) if allowed by the plan used by the client’s custodian.
To contribute for the current year, the account must be open by Dec. 31 of that year. Contributions for the prior tax year can be made up until the client files their tax return, including extensions.
Which Is Better for Your Client?
Both of these plans have potential advantages for your clients, the best plan for your client will depend upon their situation. Here are some things to consider in making your recommendation to your client:
Is their income variable from year-to-year? If so the solo 401(k) might be the better choice because of the employee deferral component that allows them to contribute the maximum amount in place for a 401(k) for that year as long as they earn enough to do so. For 2020 this means that a self-employed client who is under 50 can contribute as much as $19,500 as long as they earn at least that much. A client using a SEP and earning $20,000 would be limited to a $5,000 contribution to their account.
Does your client have employees? If yes, then the solo 401(k) cannot be used as the rules prohibit participation by employees other than the business owner, a spouse participating in the plan and any business partners leaving the SEP-IRA as the better option. If there are a significant number of employees, your client might consider a different option other than the SEP-IRA as it can be an expensive option for the business owner with a high number of employees.
Does your client need to start and fund a plan shortly before their tax filing deadline? If so then the SEP-IRA is a great option. A SEP-IRA can be started and funded right up until the client’s tax filing deadline for the prior tax year, including extensions.
Does your client want the option of funding a Roth account? If so then the solo 401(k) is the better option as there is no Roth option allowed in the SEP-IRA.
Does your client want the option to take a loan from their retirement plan? The solo 401(k) would be the better option in this case as SEP-IRAs do not allow for plan loans.
Is your client is 50 or older and do they want to be able to maximize their contributions? The solo 401(k) is the better option. SEP-IRAs do not allow an extra amount for catch-up contributions, solo 401(k)s do. For 2020 the maximum contribution for a SEP-IRA is $57,000 regardless of their age. For those who are 50 or over in 2020 the maximum combined employee and employer contribution maxes out at $63,500 for those 50 or over.