Self-Employed May Want to Move to Self 401(k)

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.

Readers Also Like:

Michael Maye is the founder and president of MJM Financial Advisors (, 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.

If you liked this article you might like

2 Obamacare Taxes Hitting High-Income Earners

Donating Car to Charity May Not Warm IRS Heart

168 Hours a Week of Retirement? Better Get a Job

Average Investor 20 Year Return Astoundingly Awful

Simplest Estate Reduction Strategy Is Generosity