If you have self-employment income, there are a variety of ways to save some taxes and put some away for retirement. As I have no employees, right now my top two choices are the SEP-IRA (Simplified Employee Pension), which I used for 2005, and the Self-Employed/Solo 401k. After a bunch of reading, here’s what it boils down to:
SEP-IRA: Allows tax-deductible contributions and tax-deferred growth. Easy to set up at basically any broker. Very minimal paperwork involved.
Self-Employed 401k: Similar tax advantages as SEP-IRA, but with more paperwork, a more limited number of administrators, and higher contribution limits.
For the details, a well-organized source of information for both SEP IRAs and 401(k)s is the Self-Employed Retirement Plans section at Fidelity.com. I also wrote up a bit on SEP-IRA basics previously.
To me, the most important difference is the contribution limits. The max for a SEP-IRA is up to 25% of compensation with a cap of $44,000 for 2006 (contribution calculator). On the other hand a Solo 401(k) allows profit sharing contributions of up to 25% of compensation plus tax-deductible salary deferrals to the plan of up to $15,000 for 2006. The cap is the same at $44,000.
So while the caps are the same, you can make very little self-employed income and basically defer it all, which you can’t do with the SEP-IRA. This gives you that added flexibility which is especially beneficial for those who have some self-employed income as secondary income and want to get the most tax advantages. For example, if you made $15,000 of eligible compensation, you could sock all $15,000 of it away with a Self-Employed 401(k), but only $3,750 with a SEP-IRA.
Of course, if your self-employed income is substantial and/or is your sole source of income, 25% may be plenty and I’d then go with the simplicity of the SEP-IRA.
There is also the new Roth Solo 401k, but it’s still really hard to find any good administrators that even offer it (I’ve been looking!). Speaking of administrators, here are my thoughts on finding a good Solo 401k administrator.