BERKELEY HEIGHTS, N.J. (TheStreet) -- On the surface, a SEP IRA appears to give a self-employed person the same benefits as an individual 401(k), with both types of retirement plans allowing for a maximum contribution of $49,000 this year. There are subtle differences that might make the individual 401(k) a better option for self-employed people, though.
An individual or solo 401(k) plan is essentially for one-person firms -- ones with no second full-time employees. (Spouses are an exception to the no-other-full-time-employees rule.) The beauty of these plans are that they are essentially 401(k) plans, but with lesser administrative requirements than a multiperson version. For example, a solo 401(k) plan is not subject to discrimination testing and not required to begin filing IRS Form 5500 E-Z until plan assets reach $250,000.
There are subtle differences from a SEP IRA that might make the individual 401(k) a better option for self-employed people.
Some of the key differences with a SEP IRA are that a solo 401(k):
- has an over-age-50 catch-up provision of $5,500, potentially increasing the annual maximum to $54,500 ($49,000 plus $5,500)
- can allow for Roth contributions
- can allow for loans
- can result in higher dollar contribution than SEP IRA at the same income level.
The solo 401(k) can result in a higher dollar contribution because of the difference in calculation methodology. With a SEP IRA, a sole proprietor can contribute a maximum of 20% of self-employment income capped at $49,000. The solo 401(k) also allows for an employee deferral ($16,500) as well as the over-age-50 catch-up of $5,500, plus a profit-sharing component.
To illustrate a higher solo 401(k) contribution: John is a 45-year-old self-employed sole proprietor. Assuming $100,000 in net profit from self-employment, John would be able to contribute $35,087 into a solo 401(k) compared with only $18,587 in a SEP IRA. The calculations are as follows:
- Net profit from self-employment: $100,000
- Half of self-employment tax: ($7,065)
- Net earnings from self-employment: $92,935
- Self-employed rate: 20%
- SEP IRA contribution: $18,587
- Allowable elective deferrals: $16,500
- Solo 401(k) contribution: $35,087
In this example with a solo 401(k), the sole proprietor can get the $16,500 elective deferral plus the profit-sharing component. With a SEP IRA, the contribution amount is limited to a maximum of 20% of net earnings from self-employment, capped at $49,000.
Self-employed people without employees using a SEP IRA may want to run the numbers and see if a switch to a solo 401(k) makes sense.
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Michael Maye is the founder and president of MJM Financial Advisors (www.mjmfinadv.com), a registered investment advisory firm in Berkeley Heights, N.J. He is a member of the National Association of Personal Financial Advisors (NAPFA) and has been a speaker covering tax topics at NAPFA's national and regional conferences. Maye has also been a frequent contributor to the Star Ledger of New Jersey's "Biz Brain" and "Get With the Plan" articles. In addition to NAPFA, he is a member of Financial Planning Association, American Institute of Certified Public Accountants, New Jersey State Society of CPAs and the Estate Planning Council of Northern New Jersey.