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Solo 401k vs SEP IRA

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As a small business owner, you might be wondering which retirement plan is the best fit for you, Solo 401k vs SEP IRA. While each plan has its benefits, it’s important to take a deep dive on which plan can provide you the greatest benefit. As a small business owner, you have multiple retirement accounts to choose from. Perhaps you’re starting wit a traditional or Roth IRA. These are great for putting some money away, but the amount you can contribute is limited. To really grow your wealth, read on to learn how retirement plans designed specifically with small business owners in mind can bring you to greater heights in your retirement planning. In today’s financial climate, small business owners have great options when it comes to planning for your financial future. Notably, two standouts in the retirement plan world are a Solo 401k and SEP IRA.

What is a Solo 401k?

Built specifically for small business owners, a Solo 401k helps you unlock bigger tax-deductible contributions, and more investment options. Simply put, a Solo 401k is a an individual 401k plan designed for a small business owner with no employees. Notably, one exception is that you and your spouse can work full-time in your business and still qualify for a Solo 401k. The IRS calls these “one-participant plans“. They’re made just for you (and your spouse) and your small business.

Eligibility is important in a Solo 401k, but fortunately numerous small business owners qualify. To have a Solo 401k, you must meet two criteria:

  1. Presence of self-employment business activity
  2. Absence of full-time* W2 employees in that business

*Part-time employee who work less than 500 hours per year are OK and do not disqualify you.

Solo 401k plans consist of two parts: A) Pre-tax (Traditional) 401k and B) Roth 401k. Not all Solo 401k plans include Roth 401k provisions. Fortunately, a Solo 401k is modeled after a larger company 401k plan. This means you capture many of the benefits of a “big” 401k, but designed specifically for your small business.

Solo 401k Contribution Limits

One main benefit to a Solo 401k plan is its incredibly generous contribution limits. In fact, a Solo 401k has the highest possible contribution limits for any retirement plan. With a Solo 401k, you can contribute up to $58,000 per year. Contribute $64,500 if you are age 50 or older. Does your spouse work in your business with you? Then each of you are considered “participants” in your company 401k plan. What this also means is that you can double your contribution amount based on what you pay your spouse!  Traditional 401k plans allow employees to save for retirement by contributing some of their compensation into a tax-deferred account. This is exactly how a Solo 401k functions as well. The more you earn, the more you can contribute. As a small business owner, this adds up to a huge tax deduction for you!

Interestingly, in a Solo 401k you really play two roles: 1) employer and 2) employee. Because the IRS views you in these two roles, you can contribute much more to a Solo 401k by tapping into each contribution type. As an employee, you can contribute up to $19,500 to a Solo 401k plan (or $26,500 if you are age 50 or older). These contributions can be 100% of your compensation. That means you can tax-defer a large chunk of your otherwise taxable income. Moreover, you can make a profit-sharing (employer) contribution of 20-25%. Do not contribute more than $58,000 (or $64,500) per participant, per year.

What is a SEP IRA?

Simplified Employee Pension Plans, also known as a SEP IRA are another retirement plan option for small business owners. Like a Solo 401k, a SEP IRA is designed to let small business owners set money aside for you and your employees. Unlike a Solo 401k, you can establish a SEP IRA if your business has part-time or full-time employees. However, if you own a business with employees you must include them in SEP IRA contributions. This means if you establish a SEP IRA and contribute for yourself, you must contribute for your employees as well. Essentially, a SEP IRA is similar to a “group” traditional IRA.

The employer establishes a SEP IRA for the business with SEP IRA components for each employee. Only the employer can contribute to the SEP IRA (employees cannot put any extra money into this account from their compensation). However, the employee is 100% vested all the time. Therefore, any money contributed to the SEP IRA for the employee belongs to him (he has full ownership of those funds).

SEP IRA contribution limits are quite generous as well. An employer can contribute 25% of each employee’s pay to a SEP IRA. The maximum contribution to a SEP IRA is $58,000 (for 2021). There is no catch-up contribution in a SEP IRA. Contributions to a SEP IRA are tax deductible, and there is no Roth SEP IRA available. As the employer, it’s important to keep in mind that whatever you contribute for yourself must also be contributed to your employee’s accounts. Therefore, if you contribute 18% of your net compensation to a SEP IRA, you must make the same contribution for each employee.

Is the Solo 401k the Same as a SEP IRA?

In the game of Solo 401k vs SEP IRA, there are notable similarities and differences. Either retirement plan is an excellent choice for small business owners, depending on your goals. A SEP IRA provides flexibility in contributing just like a Solo 401k. You do not need to contribute funds to a Solo 401k or SEP IRA each year. This is helpful for small businesses, especially early on when you are stabilizing revenue. Take advantage of higher contribution limits in the years you can max out and pull back as needed in leaner years. However, that’s where many of the similarities end.

While both plans allow a contribution of $58,000 – the how of calculating and arriving at that contribution limit differ dramatically. Only a Solo 401k allows employee salary deferral contributions. Only a Solo 401k allows you to contribute 100% of compensation for the first $19,500 you earn. You can also contribute 25% of your compensation as the employer contribution. On the other hand, a SEP IRA only allows you to put in 25% of your compensation as the employer contribution. As a small business owner, you can earn less in your business and get to a higher tax-deductible contribution amount faster. Additionally, only a Solo 401k allows catch-up contributions which can add another $6,500 in tax-deductible contributions to your retirement plan. Further, only a Solo 401k offers a Roth option. That means the only possibility for tax-free growth is in a Solo 401k, not a SEP IRA. While the two retirement plans are similar in scope, they are not the same. Solo 401ks offer greater investment choices, higher contribution limits, and more options to a small business owner than a SEP IRA.

Can You Roll a SEP IRA into a Solo 401k?

Yes, you can rollover SEP IRA funds into a Solo 401k. The IRS allows you to roll SEP IRA funds into any qualified retirement plan. A Solo 401k is a qualified plan. Rolling over SEP IRA funds or assets to a Solo 401k is easy. The Nabers Group Solo 401k provides step by step instructions and customized rollover forms to ensure your rollover happens quickly and correctly.

Many investors decide to roll funds from a SEP IRA into a Solo 401k to capture more investment options. All SEP IRA plans must be held with a custodian. This typically limits your investment options to only what the custodian/broker will provide. In contrast, a Solo 401k is fully self-directed with checkbook control. When you open a Solo 401k with Nabers Group, a bank or brokerage account are included automatically. You’re in complete control. Therefore, you decide where and how to invest your retirement funds. Solo 401k investors commonly invest in real estate, cryptocurrency, gold & silver, crowdfunding, venture capital, and start-ups in addition to traditional assets like stocks, bonds, and ETFs.

Can I have a SEP IRA and a Solo 401k?

While not common, some small business owners have both a Solo 401k and SEP IRA. Typically there’s no real advantage to keeping both plans. In comparing Solo 401k vs SEP IRA, a Solo 401k has the upper hand in multiple areas:

  • Higher contribution limits (because you can capture employee salary deferral contributions)
  • Catch-up contributions
  • Roth 401k provision
  • Participant loan

While you can have, and even contribute, to both a Solo 401k and SEP IRA in the same year – it doesn’t make much sense for most investors. Generally speaking, if you have part-time employees (500+ hours per year) or full-time employees (1000+ hours per year), then a SEP IRA is the right choice for you. However, if you do not have any employees (other than you or your spouse), a Solo 401k is the way to go. Further, contributing to a Solo 401k does not affect your ability to have or contribute to a traditional IRA.

How to Set up a Solo 401k

These days, it’s amazing to see how many retirement plan options there are for small businesses. Having a self-directed retirement plan for your small business can set you on the path to financial freedom. With incredible benefits like big tax deductions, every small business owner should consider a Solo 401k or SEP IRA. Ultimately, a Solo 401k offers you bigger contribution limits, Roth provisions, loan options, and catch-up contributions. This makes is a clear winner when weighing a Solo 401k vs SEP IRA. If your small business doesn’t have any employees, a Solo 401k may be the right choice for you.

Click here to get started with your very own Solo 401k today and start building your wealth for a brighter financial future.

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