Is A Solo 401(k) Or An SEP-IRA Better For A Small Business With No Employees?
Now that this tax season is over, it’s time to start planning for the next one. If you own a small business, this means you.
The U.S. Small Business Administration reports the number of small businesses with no employees increased from 15.4 million in 1997 to 23.8 million in 2014. A business without any employees has a different calculus when it comes to deciding on a retirement plan. This often involves moving away from the options owners might be most familiar with.
If you’re a typical retirement saver, you’re probably very aware of IRAs and 401(k) plans. Small business owners can certainly use either of these popular retirement saving vehicles, but they each have their drawbacks.
The IRA suffers from having the lowest maximum annual contribution ($6,000 beginning in 2019, with an additional $1,000 “catch-up” provision for those aged 50 and above). The traditional 401(k) plan, designed for businesses with multiple employees, presents greater costs and administrative burdens than may be needed or necessary.
Of the other retirement saving options available to them, small business owners may find the SEP-IRA and the Solo 401(k) most attractive.
Which one is better for you?
While both feature much higher contribution limits than a traditional IRA, they don’t have the same high costs and reporting requirements as a traditional 401(k). The time of year and your future intention regarding hiring employees can play a role in determining which option is most appropriate for your business. In addition, several other factors may influence your decision.
Before you choose between an SEP-IRA and a Solo 401(k), here are a dozen questions to consider. Answering them today might help you avoid unpleasant experiences tomorrow.
Is it past the contribution tax year?
Depending on the time of year you ask this question, you may find you’ve eliminated one of the options right off the bat. The IRS says, “You can set up an SEP-IRA plan for a year as late as the due date (including extensions) of your business’s income tax return for that year.” This means, for example, if you’ve received an extension on last year’s tax filing, you can still start an SEP-IRA.
Unlike the SEP-IRA, a Solo 401(k) must be established by December 31st of the tax year for which the contributions are made. If you’re thinking of setting up a Solo 401(k) for last year, it’s too late. Still, there may be some (albeit very limited) wiggle room if can plan ahead. The next question offers one suggestion.
Is there a chance you might want to wait until after the tax year to fund the plan?
In general, there are two kinds of contributions that go into a retirement plan. An employee’s contribution is called an “elective deferral.” In addition to that we have the “employer contribution.” To maximize your Solo 401(k) contribution, you must use both an elective deferral and an employer contribution. An SEP-IRA has no elective deferral. All contributions to SEP-IRAs come from the employer.
Because each type of contribution has its own deadline, your expected timing of those contributions can tell you which plan might be better for you. “If you have an SEP, you can fund it as late as your extended tax return,” says Michael Sedlak, Founder and Managing Member at Golden Trail Advisers, LLC in Burr Ridge, Illinois. “If you do a Solo 401(k), you can fund the employee portion of up to $19,000 or $25,000 if you are 50 or older by January 31 (with some wiggle room) and the employer portion of up to $37,000 as late as your extended tax return.”
Of course, this assumes you’ve already established the Solo 401(k) during the tax year for which the contribution is made. But, what if you’re not sure which type of retirement plan you’ll want to establish? (You’ll see there may be a very good reason for this question in a moment.)
“If you decide to set up a retirement plan after 12/31, you can only use an SEP-IRA and not a Solo 401(k),” says Sedlak. “If you are not sure which plan would be better, you can set up the Solo 401(k) before the end of the year and wait to fund the Solo 401(k) or an SEP-IRA after consulting with your CPA.”
Might there be a risk to funding early?
Here’s the reason why you might be hesitant to pick a plan during the tax year for which it will first apply. “One cannot determine the funding maximums for either plan type until year-end books are completed,” says Mark Wilson, President of MILE Wealth Management in Irvine, California.
That’s the risk with starting too early to fund either option. You may find that you’ve overfunded the plan. There are different contribution methodologies for each plan, so one may be preferable to another based on how much you’re able to contribute.
Are you looking for the lowest-cost option?
Here’s a question that’s normally the first question. It falls to number four on the list because the first three may limit your options; thus, obviating the need to even consider this question (and all the remaining questions).
Both plans require adoption agreements over and above a typical IRA. Since these remain single employee plans (although spouses may be included), custodians often offer boilerplate adoption agreements. The use of these pre-approved agreements can keep costs low (although higher compared to traditional IRAs). In general, SEP-IRAs tend to be lower cost, especially as the plans grow beyond $250,000. That’s when the IRS requires Solo 401(k) plans to file a Form 5500-SF (or Form 5500-EZ). SEP-IRAs do not have to make these filings.
Are you looking for the simplest and easiest option?
Aside from cost, there’s also ease of use. Sedlak says “while neither plan type is complicated, a SEP is slightly simpler than a solo 401(k).”
Do you want a Roth Option?
Here’s where you get to an important distinction between the two options. You may establish a Roth version of a Solo 401(k). The SEP-IRA, however, does not permit you to have a Roth with the SEP-IRA (although you may still contribute to a traditional Roth IRA if you are eligible).
This may be a critical question, especially if the owner is currently not permitted to contribute to a traditional Roth IRA. “If you are a business owner but make too much to contribute to a Roth IRA, a Solo 401(k) is a way to make a Roth contribution and gain the benefits of long-term tax-free growth,” says Colin Exelby, President of Celestial Wealth Management in Towson, Maryland.
There’s another specific situation where the availability of a Roth option is critical. Suppose the owner of the business is a minor child and wishes to create a turbo-charged version of a Child IRA. In this specific case, since it’s likely the child won’t have dramatic earnings and therefore be in the lowest possible tax bracket (if not in the zero tax bracket), a Roth option is likely the preferred choice.
Do you want to make the highest possible contribution?
Now we’re getting to the nitty gritty. This is where the rubber meets the road (or whatever tired cliché you prefer). Which of these options allows you to make the highest possible contribution?
As luck (and public policy) would have it, the standard contribution limit for both plans is $56,000. How you get there is a bit dicey. Remember what was said earlier about two different types of contributions? That comes into play here and our next two questions address this.
Do you earn more than $280,000?
Why is $280,000 the magic number? In general, beginning in 2019 SEP-IRA owners may contribute a maximum of 25% of their compensation up to $56,000 in any one year. That means compensation up to $280,000 can be considered when calculating the annual contribution. So, if you’re earning more than $280,000, salary is not a determining factor in your choice.
Do you want to contribute your entire earnings?
On the flip side, what if you wish to contribute your entire earnings? As long as you don’t earn more than the standard maximum contribution of $56,000 a year, then you’ll want a Solo 401(k). Again, this scenario really suits the child entrepreneur who wishes to go beyond a typical Child IRA. But it may well be relevant for others, too.
“The great benefit of a Solo 401(k) versus an SEP-IRA is how much you can contribute to the account, especially for those earning a middle-class income,” says John Madison, Personal Financial Counselor at Dayspring Financial Ministry in Ashland, Virginia. “Suppose you own and operate an S-Corporation, paying yourself $50,000 a year. An SEP-IRA would limit you to a contribution of 25%, or $12,500, of your wages. With a Solo 401(k), you could contribute $19,000 (under 50) or $25,000 (50 and over), plus add in a profit-sharing provision for another 25% of your wages.”
Are you age 50 or above and wish to take advantage of a catch-up provision?
We’ve been talking about the “standard deduction” of $56,000. For those age 50 and above, the IRS allows you to contribute above this standard deduction in an effort to “catch-up.” Alas, this catch-up provision is only available for employee contributions, not employer contributions.
Since the SEP-IRA is only an employer contribution, it does not allow any catch-up contribution. Eligible owners, however, may still take advantage of the $1,000 catch-up provision as it relates to traditional IRAs.
The Solo 401(k), which includes an employee contribution, therefore does permit a catch-up contribution. Like any other 401(k) plan, the catch-up in this case is $6,000.
This dramatically impacts the math when comparing the two plans for small business owners age 50 and above. This catch-up provision creates a significant difference between the two plans in terms of the maximum allowable annual contribution. The SEP-IRA maximum remains at $56,000, while the Solo 401(k) maximum grows to $62,000.
That’s a big enough difference to impact the decision for some owners.
Do you think you might need to take a loan from your retirement savings?
Here’s yet another big difference. Once more, the scales may tilt in favor of the Solo 401(k) – but only if you feel it’s in your best interest to take a loan from your retirement plan. You can do that with a Solo 401(k). You can’t take a loan from your SEP-IRA.
Do you expect to hire employees in the future?
Finally, we get to a question where the SEP-IRA comes out ahead. Our assumption in this entire article has been that the business has no employees. It consists of a single owner (and perhaps a spouse). This arrangement produces specific advantages regarding retirement plans. The answers to the above questions address those advantages.
But what if your business grows and you’d like to hire an employee (or two or three or more)? This takes the simple calculations we’ve been using and throws the monkey wrench of complication into the whole works.
Clearly, the retirement plan decision will need to be recalibrated. How immediately must this be done? It turns out the SEP-IRA buys you more time. “With a Solo 401(k) plan, employees are eligible if they work more than 1,000 hours. Not so with the SEP-IRA,” says Dr. Guy Baker, Founder of Wealth Teams Alliance in Irvine, California. “Employees can be restricted from joining until they have worked more than 1000 hours, three of the last five years.”
So, which is best for you? The SEP-IRA or the Solo 401(k)? Bear in mind the date of this article, as tax laws evolve over time. It therefore makes sense to run your answers by an able advisor before you go making any potentially life-altering decisions.
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