Self-Employed Solo 401k vs. SEP-IRA Basics

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.

Comments

  1. This is good information. Let me ask you a question, if you own a company (S Corp or LLC), how do you structure your income so that part of the earnings will stay in the company and part of it goes to your pay check?

  2. Well an S-Corp and LLC is usually passthrough – so most of the income ends up on your own tax return anyways.

    If you are talking about saving on self-employment taxes by separating between salary and profit distributions, you pretty much just write out a corporate resolution (at least for S-Corp) outlining the salary and distributions. Some suggest paying salary monthly and distributions quarterly so they are more separate.

    For the salary, most people hire a payroll company because you need to withhold taxes and stuff regularly and follow a lot of guidelines. You can do it yourself if you are good with deadlines and filling out tax forms.

  3. I currently have a full time job which offers a 401k plan that I take part in. I also have a LLC for a side biz I do. Do you know, Jonathan or anyone else, anything about eligibility or limitations of me having a SEP-IRA or a Self-Employed 401k with my side biz… since I have the 401K from the full time job?

    In my own research, I’ve found conflicting information on this.

  4. mokume – For 401ks, what you have to do is separate salary deferrals and profit-sharing distributions.

    Here is the key point: No matter what kind of 401k (Solo or not), you can only defer a total of $15,000 of salary a year.

    The profit sharing is separate, and you can defer 25% up to the $44,000 cap. So to max out that cap you’d want to do salary deferral mostly on your non-Solo 401k.

    So similarly, if you have a SEP-IRA and make over $200,000 in your side biz and also max out your non-Solo 401k at work at $15,000, you could technically set aside a max of $15,000 (non-Solo 401k) + $44,000 (SEP-IRA @ 25%) = $59,000 a year.

    Hope that made sense, it wasn’t written that well. :)

  5. Jonathon – I believe the 44k is a maximum aggragte limit all around, not 59k. I could be wrong. Anyone?

  6. I’m not 100%, I just got this from talking to the Fidelity rep over the phone, but they’ve been pretty on the ball so far.

  7. After reading Pub 560 from the IRS, I think that Wes is right, but it’s confusing as you have to differentiate between an employer contribution and employee contributions. If anyone is considering contributing more than $44k, (first of all congrats on making over $200k a year) I’d consult a tax advisor and not go off this anyways.

  8. I’m pretty sure the maximum aggregate limit is $44k ($15k salary deferal AND 25% of pay aggregated). However, there are other techniques to save even more – depending upon your age – up to $150k per year total. However, you generally need to be self-employed earning large amounts of money to do it.
    The approach is to create a combined DBDC plan (a combined pension and individual 401k). There are many details and additional expenses here as you must hire a small business pension administrator, BUT if you can CONTINUOUSLY fund your pension each year – it’s not optional, you can save alot more money tax free.
    In my later 30s, I could probably svae $60k per year. Someone in their 50s could probably save > $100k per year.
    Regards,
    makingourway

    PS I plan to write about this in the future on my blog. I’ve been interviewing providers.

  9. I have a SEP-IRA that is nearly maxed out for the year, but I am finding that I would contribute more if I could. Would anyone know if it’s possible to open an individual 401(K) and contribute, say $15,000 of self-employed income, before the end of the year?

    I haven’t been able to find anything regarding use of both SEP-IRA and an Ind. 401(k).

    I suppose for next year I’ll only go the 401(k) route, and leave my SEP alone.

    Many thanks,
    -Eric

  10. Eric,

    You can contribute to both plans, however, your aggregate contributions between the two cannot exceed the current limit for defined contribution plans. I think it’s either 25% of your income or $43-$45k.

    It is important to note that you CAN defer the first $15k of your income (regardless of how much you earn) into an individual 401k.

    Hope this helps, makingourway

  11. It looks like T. Rowe Price now offers a Self-employed Roth 401(k) plan: link

  12. DavidinDenver says:

    I have a single member LLC. But, because I do business in Canada, I have had to elect s-corp status for my LLC so that I come under the US/Canada Tax Treaty. I am the only employee (and principal) in the business.

    As such, I have to pay myself a salary. Is it still true that my maximum SEP contribution is limited to the salary I pay and not to the salary plus K-1 earnings?

    If so, how would you structure a SEP and solo 401K so I could maximize my retirement savings. I do like my SEP because it is so easy. But, I don’t like the fact that the contribution limits are set based on salary and not salary plus K-1 earnings.

    Thanks,
    David

  13. I am a small business owner. I have been in business for 8 years. I started a SEP plan for myself two years ago to save on taxes. Now my finacial instutition that governs over my SEP plan says I have to provide it to my employee who has two years of service.

    Is this true? Every publication I read says it is on a volenteer basis.
    My bank is almost forceing me to do this. Any help would be most appreciated..

    Cathy

  14. From what I’ve read, an advantage of the Solo 401k over a SEP is that you can borrow from the 401k. That way, if you need the money, at least you’re in debt to yourself.

    I think a downside may be administrative costs – do you know anything about that?

  15. Cathy: Your employee usually must meet (3) requirements.
    1. Be 21+ years old
    2. Have been employed by you for 3 of the last 5 yrs.
    3. Must earned $450+ in compensation for the year.
    However, you can set the requirements to be less restrictive with IRS Form 5305

    If your employees meet the above requirements, then per the IRS publication YOU MUST contribute the same percentage amount to their SEP-IRAs based on their gross income. So if you contribute 25% of your income to your SEP-IRA, then you must do the same for theirs.

    If this is not viable for business, then your next best option is to open a regular 401(k) for your company which requires a lot more paperwork and maintenance.

  16. Hi,

    I have a question about Solo 401k. I am currently employed in a company and on payroll, so I get a salary and my company also has a 401K plan so I contribute to that.

    Now my company which is a S corp has offered me shares so now I am also one of the members of the S corp. I will be getting my share of the profits added to my share base instead of being paid out. In this scenario can I contribute to a Solo 401K in addition to the normal 401K I already have.

    Any response is highly appreciated.

    Thanks

  17. I have a sole business with a SEP-IRA
    I can put away up tp 25%. max 44k
    But now I’m going S corp.
    the best retirement accrding to my accounting
    is a simply IRA.
    But now my limit is 10k and the company match is $1,300.00
    giving me a total of $11.300 per year.
    I didn’t like the idea of it, because I wanted to put $30k
    each year into my retirement.
    only reason I’m going Sub S corp.
    I was advised by my accounting
    I will save $8.000 on social security tax’s.
    plus not have my personal assets at risk.

    But now I have to change everything
    My plan is:
    I figure $11,300 in simply IRA
    I could also change health insurance deductables and open a HSA
    put $5000.00 a year there.
    open a Roth IRA (none tax deductable) and put $4000. there
    to help pay for taxes on the Simply IRA
    & HSA when I deduct it when i retire at 60.

    Any body have any other ideas
    to lower taxes and save more for retirement.

  18. Here’s a question: I am self-employed. Can I defer (as an employee) the full $15,500 every year WITHOUT making profit sharing contributions (as an employer)? Or do I have to do both? Is there a tax advantage – now and when I come to make distributions – to making profit sharing contributions versus salary deferrals?

  19. As anyone compared the ROTH 401k w/ solo 401k? Could you possibly contribute to a SEP IRA, to maximize tax advantage and also contribute to a ROTH 401k.

  20. I am about to roll over money in a previous employer’s plan into an a self employed 401K. The main difference to me between 401 and IRA
    is asset protection. All 401 K money is protected from creditors,whereas IRA is protected up to 1MM only if you file bankruptcy. High risk folks such as physicians should be aware of this .

    This year,I would like to set up and Fund A ROTH 401K. Does Fidelity or other Fund/brokerage offer these at reasonable cost?

  21. Yes, Fidelity and T. Rowe Price both offer a Roth 401(k) option. Haven’t checked with the major brokers, (Ameritrade, Schwab, E Trade), but they’re worth looking into.

  22. I am self employed and have recently discovered the huge benefits of SEP. Is there a good SEP IRA calculator where I can estimate how much my SEP contributions will grow to once I retire? The traditional calculators have a $4,000 ceiling. I’m currently 35 and have a limited mount in a traditional IRA.

    Thanks,

    Ari

  23. If you start an LLC and a Solo 401(k), could you purchase your own company’s stock under that plan? Debt instruments?

    Would there be similar provisions for a ROTH IRA?

  24. Lawrence Groves says:

    Chris:
    The problem with purchasing your own company’s stock is twofold:
    1. You will be self dealing with the plan’s asses which is prohibited by the IRS
    2. If your company is new, the stock has little or no value so the Solo 401k plan could not pay much for it if it could.

    The plan type you might consider is an ESOP- Empoyee Stock Ownership Plan. It allows for the purchase of all of the Company stock.

    Otherwise, set up the solo 401k plan and you can borrow up to $50,000 or 50% of the account value, whichever is less.

  25. I’m a Realtor with an S-Corp. Can I have a Roth IRA, SEP IRA, and Self Employed 401k plan and max out each?

  26. Michael Howard says:

    I’m starting out and looking for a retirement plan. I am self-employed and will be starting at 260,000/year gross. With minimal tax deductions (no overhead or employee costs) which route would be the best for maxing out my contributions a SEP or Solo 401k. Everything I have read is pointing to the SEP when income exceeds 200K.

  27. Excellent comparison of Self-Employed Solo 401k vs. SEP-IRA.

  28. Client who is a member of a two member LLC. All net income was paid to her in the form of a guaranteed payment leaving the LLC with no cash. She has $95,000 in guaranteed payments and $0 of allocated business income. How does she fund a SEP IRA contribution?

  29. I have been told that with my LLC wich i file income on a schedual c and pass thru to my 1040 tax return that i cannot contribute to a SEP or any 401k from my business as a tax deductable bennifit. ie: self employed

  30. I have an individual Roth IRA that I’ve had for a while and contribute the max each year. I used to also contribute to my companies 401K at the same time. Now I am Self Employed I am looking at a SEP_IRA. Can I continue to contribute to my Individual Roth and a SEP-IRA and max them both out?

Trackbacks

  1. [...] As I’ve mentioned in my SEP IRA versus Solo 401(k) comparison, the problem with the additional paperwork involved with a 401(k) is that you have to find an administrator that is willing to do it for you at minimal cost. Compare that with the SEP-IRA, you can usually walk up to many brokers, open up an account, and start trading anything with no annual fees and just commissions. [...]

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  3. [...] My Money Blog has an insightful post about retirement savings plans for the self-employed. It looks at the differences between SEP-IRAs and self-employed 401(k)s. [...]

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