For years, the SEP IRA was the gold standard retirement plan for the self employed. High contribution rates? Check. Easy to open? Check. Flexible investments? Check. However, the SEP IRA is getting some competition, from the solo 401(k) (a.k.a an individual, or self employed 401(k)). My buddy, and hotshot business owner , Marvin asked me the best retirement plan for him over dinner the other night. Unfortunately, this was the same time as my rice pudding food coma started to set in. This article is for you Marvin, and anyone else who wanting to know the best retirement account for small business owners.
There are really three popular retirement plans for self employed individuals; SEP IRA, solo 401(k), and SIMPLE IRA. I’m not going to get into SIMPLE IRAs, as the contribution limit is so small, at only $12,500 in 2018. The goal of most retirement plans is to maximize your pre-tax contributions, and a SIMPLE IRA just isn’t going to cut it. If you run a small business with 10 or 20 employees, a SIMPLE IRA may be right for you, but not if you are the only employee.
As I mentioned before, SEP IRAs used to be the go-to if you were self employed. The ease and low cost to open and large contribution limits, make them very attractive. SEP IRAs can be set-up if you are self employed but can also will work if you own a small business with other employees. However, if you own a small business, all employees need to earn the same benefits and the employees can’t make contributions.
Ten years ago, solo 401(k)s were not popular because they were costly and not easy to open. Today, solo 401(k)s have become low cost, much easier to open, and the high contribution limits have made them very attractive. Solo 401(k)s are only applicable if you are the only employee or if you and your spouse are the only employees.
Solo 401(k) vs. SEP IRA contribution limits
Or, as my friend Marvin put it, “Which account allows me to pay the least to the government?” In the surface, it appears that the contribution limits for both SEP IRAs and solo 401(k)s are the same. In 2018, you can contribute a maximum of $55,000 to both accounts. However, when you dig a little deeper, there may be a huge difference in how much you can actually contribute to the two accounts.
SEP IRAs allow a maximum contribution of $55,000, but you are also limited to 25% of your net earnings if you are self employed. For example, if your net earnings are $100,000, you can only contribute $25,000 to a SEP IRA. You actually need to have net earnings over $225,000 in order to be able to contribute the maximum amount of $55,000.
For those earning under $225,000, you will probably find that you can contribute more to a solo 401(k). A solo 401(k) allows you to make an employee contribution up to the 401(k) limit for the year. In 2018, this limit is $18,500 plus an additional $6,000 in catch-up contributions if you are over the age of 50. In addition to the employee contribution, you are also able to make an employer contribution. If you are a sole proprietor or an LLC, the employer contribution can be up to 20% of net income. So, like the example above if you have $100,000 of net income, you would be able to contribute $38,500 ($18,500 employee contribution plus $20,000 employer contribution). In this example, a person with $100,000 of net income can contribute $13,500 more in a solo 401(k) compared to a SEP IRA.
Below is a chart the breaks down your max contributions to a SEP IRA and solo 401(k) at different amounts of net earnings. You can also contribute an additional $6,000 to a solo 401(k), if you are over the age of 50.
2018 Contribution Limits at Different Levels of Net Earnings
|Net Earnings||SEP IRA Contribution||Solo 401(k) Contribution|
As mentioned before, you will typically be able to contribute more to a solo 401(k) when your net earnings are less than $225,000. You will also be able to contribute more above $225,000 to a solo 401(k) if you are eligible to make the additional catch up contributions.
There are other benefits that solo 401(k)s offer not available in a SEP.
IRAs don’t allow loans, and SEP IRAs are no different. However, your solo 401(k) may have a loan provision. Not a bad feature for a small business owner that needs access to cash quickly. If your solo 401(k) custodian does allow for loans, the maximum loan amount is either $50,000, or ½ of your account balance, whichever is lower.
The first time I had heard of a solo 401(k), was a few years ago. A client had called me up because he was going to buy a rental home using a solo 401(k). “Wait, you’re going to spend half your life savings buying a rental home in this investment that I’d never heard of?” Well, the answer was yes. He hooked up with a company that specializes in buying income properties in a solo 401(k). A few months later he was the proud owner of a rental property. I’m not saying this is a good idea, but it is an option.
Outside of rental homes, a SEP IRA should have the same investment options as a solo 401(k). Mutual funds, ETFs, stocks and bonds are common investments in both types of accounts.
If you are making less than $225,000 of net self employment income, you may want to ditch the SEP IRA and open a solo 401(k). You will be able to contribute more and have the same investment options. Not to mention, you may even have the option to take a loan if necessary from a solo 401(k). If you are self employed and have no employees, and looking to maximize retirement contributions, the solo 401(k) is probably your best option. Also, if you are in downtown Detroit, try the rice pudding at Chartreuse. It’s amazing.