Clients who are self-employed need to save for retirement and will benefit from advice regarding the best self-employed retirement plan for their situation. The Solo 401(k) and the SEP-IRA are two popular options. Here are some of the features of both types of plans to consider.
SEP-IRAs are a type of IRA account that is available to small businesses. SEP stands for Simplified Employee Pension. SEP plans are easy to establish and offer business owners relatively high contribution levels depending upon their income level. Though employees other than the owner are eligible, in reality SEPs can get expensive if contributions are made for employees. It should mostly be considered a self-employed retirement plan option.
All contributions made to SEP-IRA are employer contributions. Unlike with a 401(k) plan, there are no employee contributions. Contributions can be made for up to 25% of your compensation up to a limit of $57,000 for 2020. A few other features of a SEP-IRA:
- A SEP-IRA can be established and funded up to the date the client files their tax return for the prior calendar year including extensions. This date will vary based upon the client’s business structure, including whether they file a corporate return or as a Schedule-C sole proprietor. This can provide planning flexibility for some clients.
- For some sole proprietors, that actual contribution rate might be limited to 20% of their compensation due to the way in which self-employment income flows through the calculation.
- Generally, SEP account holders can invest in anything any other IRA account holder can at the custodian where the account is opened.
- A SEP-IRA can be opened by sole proprietors, corporations, partnerships and other types of small business entities.
- Contributions to a SEP on behalf of the owner or any employees are immediately vested.
A few other things to know about SEP-IRA plans:
- There is no Roth option available with a SEP.
- Loans are not available from a SEP.
- Contributions to the SEP can be limited by the client’s income for a given year.
Solo 401(k) Basics
Participation in a Solo 401(k) is limited to business owners and a spouse who is involved in the business. Any other employees involved in a business are not eligible to contribute.
A Solo 401(k) offers the opportunity to make both employee contributions and employer profit sharing contributions. The employee contribution limits are the same as for a regular employer-sponsored 401(k) plan: $19,500 with an additional $6,500 catch-up contribution for those who are 50 or over at any point during the year.
Additionally, employer profit sharing contributions can be made up to 25% of employee compensation up to a combined maximum of $57,000 and $63,500 for those 50 or over for 2020.
To contribute for the calendar year, the plan must be established by the end of that year in order for contributions to be made that would impact that year. Employee contributions should be elected by the end of the year, clients have until their tax filing date (including extensions) to make the actual contribution. Likewise with making their employer profit sharing contribution as well.
Unlike a SEP-IRA, a Solo 401(k) can offer a Roth option for the employee contributions. All profit sharing contributions must be made to a traditional account. Additionally loans can be taken for the plan if allowed in the plan document.
Which plan is better for your clients?
The answer to this will depend on each client’s situation. A few things to consider in advising your self-employed clients:
- The SEP-IRA is easy to set-up and requires virtually no administrative work. The ability to establish and to fund the account right up until your client’s tax filing date offers a high degree of flexibility for your clients
- For clients with income that varies from year-to-year, they might be better off contributing to a Solo 401(k). Since the amount that can be contributed to the SEP is totally dependent upon the client’s earnings, the amount they can contribute will be limited in years where their income is low. As long as the client earns at least $19,500/$26,000 they can contribute these amounts under the employee contribution component.
- For clients who want to be able to make Roth contributions or be able to take a loan out from their plan, a Solo 401(k) might be the better option.
In general, if a self-employed client doesn’t have any employees and consistently wants to be able to maximize their retirement contributions, a Solo 401(k) will be the better option in many cases.