Solo 401k or a SEP-IRA, which one is the best retirement plan for the self-employed?
When I told you about my struggles with my Solo 401k contribution at Fidelity, Lee suggested I look at the SEP-IRA, which made us take a step back and relook at all the available plans; the Solo 401k, the SEP-IRA, and the SIMPLE IRA.
All three plans are available to sole proprietors, partnerships, and C or S corporations.
I promised to share my perspective after we highlighted each plan. Here’s my take:
When You Want a SEP-IRA
There are a few instances that a SEP-IRA is your obvious choice:
Do you have employees? If the answer is yes, you’re going to want to open a SEP-IRA. You cannot open a Solo 401k if you have employees; it’s only for the business owner and spouse.
Is the calendar year over? If the answer is yes, and you still want to make a contribution for the prior tax year, the SEP-IRA is the way to go. You can open and fund a SEP-IRA until the tax filing deadline, plus extensions. In contrast, a Solo 401k has to be established by December 31, but can be funded until the tax filing deadline, plus extensions. If you are planning for next year, act now, and you can establish either plan.
When You Want a Solo 401k
Are you planning Roth conversions? A benefit of the solo 401k is that you won’t have to include the contributions in the pro rata calculation. However, a SEP-IRA will be included in the Roth IRA Conversion calculation.
If you have any plans to make Roth conversions on non-deductible IRA contributions, steer clear of the SEP-IRA, or you’ll be increasing your tax bill on the conversions.
Do you want to maximize your deferral? The Solo 401k is the big winner. Here are the contribution limits:
- 2009 Solo 401k Limits: $16,500 employee deferrals ($22,00 age 50 or older) plus 25% of compensation; maximum of $49,000($54,500 age 50 or older).
- 2009 SEP-IRA Limits: 25% of compensation; maximum of $49,000.
While the limits appear similar, each having a $49,000 maximum, they actually aren’t. Let’s take a closer look at the calculations.
Calculating Maximum Contributions
To calculate the 25% profit sharing contribution, you need to account for the deduction of the plan contribution in the formula in addition to half the self employment tax. So a 25% contribution rate, looks like this:
(Net income – 1/2 self employment tax – profit sharing) * .25 = profit sharing.
It’s actually the same as a 20% self employed rate, which some people prefer to use:
(Net income – 1/2 self employment tax) *.20 = profit sharing.
Here’s an example:
Let’s say your net income is $20,000. Half of your self employment tax is $1412.96. So your profit sharing contribution is $3717.41.
($20,000 – $1412.96 – $3717.41) * .25 = $3717.41
or ($20,000 – $1412.96) * .20 = $3717.41
For the solo 401k, you can defer 100% of your compensation. To calculate your compensation use the prior formula: (Net income – 1/2 self employment tax – profit sharing). ($20,000 – $1412.96 – $3717.41) = $14869.64. Add the profit sharing contribution to the employee deferral ($14869.64 + $3717.41) = $18587.05.
Total solo 401k contribution: $18587.05
Total SEP-IRA contribution: $3717.41
As you can see, this is where the solo 401k is the big winner. If you want to skip the hand calculations, you can use a calculator to determine your maximum contribution.
What about the SIMPLE IRA? I didn’t include it, since the contribution limits don’t even come close to the Solo 401k or the SEP-IRA. If you have employees, and want to let them make contributions, it might be a good choice, however, at that time, you’ll want to compare the SIMPLE IRA to a 401k.
I decided to stick with the Solo 401k since the plan contributions are so much higher and our goals are to defer the maximum amount of money. In addition, we’re planning Roth conversions in 2010, so I want to minimize our taxes for the conversions.