If Family Feud asked one hundred people to name a type of IRA, Steve Harvey's mustache would most likely reveal the top three answers as Traditional, Roth and SEP IRA. Sadly, this is about the extent of the average person's retirement planning knowledge and can potentially cost small business owners thousands in tax savings when setting up a retirement plan for their business. If you're a small business owner, specifically a one-man shop or sole proprietor, expand your vocabulary past the three letter word SEP.
Solo 401(k): The Basics
One similar option to the SEP IRA is what's known as a Solo (or Individual) 401(k). You may have heard of, or even participated in, a 401(k) at a previous employer. If so, the concept is simple, a Solo 401(k) is a 401(k) for a business that is owned by one person with no employees. (A Solo 401(k) can also be used in certain instances involving partners or a business that is owned jointly with a spouse). For our purposes however, let's focus on strategies for a business with one owner and no employees. The primary benefit of a Solo 401(k) is the ability for the business owner to contribute not only as the business owner, but as an employee as well. This gives the owner flexibility that a SEP simply cannot provide.
Tax Implications: Know Your Options
For 2016, both the SEP IRA and the Solo 401(k) have an annual contribution limit of $53,000. Although the limits are the same, the method of reaching those limits are different. The SEP IRA only allows contributions to be made by the business and is limited to the lesser of $53,000 or 25% (20% if sole proprietor or single owner LLC) of earned income. Conversely, the Solo 401(k) allows a business owner to contribute $18,000 as an employee (with an additional $6,000 catch-up after age 50) and as the employer through a profit-sharing provision designating up to 25% of total compensation.
For example, Mr. Client is a 51-year-old consultant with no employees. He operates his business as an S corporation and earns $100,000 annually in W-2 Wages. For the 2016 calendar year, Mr. Client can defer up to $18,000 of his salary, plus he can make a $6,000 catch-up contribution, (because he is over age 50), for a total salary deferral amount of $24,000. He can also make a 25% profit sharing contribution -- $25,000 based on his $100,000 salary. The total contribution Mr. Client can make to his Solo-401(k) plan for 2016 is $49,000. Had he funded a SEP IRA instead, he could have contributed a maximum of only $25,000.
Roth Provision: A Powerful Tool
Stephen Rischall, CRPC and Financial Advisor with 1080 Financial points out that a, "SEP IRA is always pre-tax funds, as such the business will receive a deduction for the tax year in which contributions are made. (Contrarily), a Solo 401(k) can allow for Roth contributions (through) personal income deferrals; however, the profit-sharing contributions (will) be pre-tax." This can be a powerful tool for individuals making over $132,000 or married individuals filling jointly making over $194,000 that would not normally be able to make Roth IRA contributions. Through the use of the SOLO 401(k) an individual can now make Roth Contributions at any Income level.
Loan Provision and Murphy's Law
Although a 401(k) loan should always be a client's last resort, it can be a beneficial alternative to taking an early withdrawal from an IRA. Murphy's law: Anything that can go bad, will go bad. Hard times are inevitable, and more often than not when a client experiences hard times the first place they draw money from are their retirement accounts. Even if a client qualifies for a "hardship withdrawal" they will still have to pay taxes on their distribution. If they don't qualify for a hardship withdrawal, then tack on another 10% in penalties for an "early distribution". With a Solo 401(k) an individual can borrow up to 50% of their account value, not exceeding $50,000 in total. Contrarily, if those same dollars were inside a SEP IRA, an individual would be unable to take a loan as SEP IRAs do not allow loans.
Kevin M. O'Brien, CFP, AIF, CAP and President of Peak Financial Services expanded on how he used this loan provision and Solo 401(k)s for his clients. "A few of my clients who lost corporate jobs during The Great Recession, established consulting practices, which enabled them to roll over retirement plans to Solo 401Ks. With the loan provisions in Solo 401Ks, they weathered the storm without taking hardship withdrawals and having to pay taxes on plan distributions. They did this all while establishing new businesses. If they rolled over the money to a SEP IRA, they wouldn't have had this flexibility."