There are very few home runs in the retirement planning industry, but choosing a solo 401(k) - also known as an Independent 401(k) - over the SEP IRA is clearly one of them. If you are a sole proprietor or self-employed and you want to maximize retirement contributions with the lowest cost and highest flexibility, check out six reasons why the Solo 401(k) may be a good fit for you.
Advantage No.1: Higher Contributions Allowed
The advantage of the Solo 401(k) is that the maximum pretax contributions are higher at every level of net earnings before qualified plan deductions for the Solo 401(k) than the SEP IRA. The following shows the maximum contributions at varying income levels and illustrates that the difference between the two can be considerable.
For example, at $60,000 of net earnings, you can contribute up to $35,152* (including Catch up Contribution) to the Solo 401(k) while the SEP IRA is maxed out at only $11,152*. That is a $24,000 difference in favor of the Solo 401(k). Similarly with $100,000 net earnings, Solo 401(k) maximum contributions would be $42,587* while SEP contribution will be limited to $18,587*. It is interesting to note that SEP contributions catch up with 401(k) contribution at net earnings of about $184,800*. At that point, Solo 401(k) still offers higher contribution for individuals over 50 because 401(k) has the catch-up provision for individuals over 50 while the SEP IRA does not.
The solo 401(k) beats the SEP IRA for the maximum plan contribution no matter what the net earnings. For sole proprietors living in high income tax states and for those with additional outside sources of income, this difference could be the difference between a refund and a bill at tax time.
Advantage No.2: More Flexibility
Contribution to 401(k) pan as well as SEP are not mandatory every year. In addition, 401(k) allows tax free loans up to $50,000 or 50% of the value of the plan, whichever is lower. This allows sole proprietors to manage their cash flows and contribute the maximum amount in good years while contributing less or nothing, or even borrow from the 401(k) plan should the business take a turn for the worse. SEP does not allow loans.
Advantage No.3: Easy to Setup, Low Cost and Flexible
Both the solo 401(k) and SEP IRA are easy to open and manage. If opened at a discount broker, it is possible to have practically no cost other than trading. Both are extremely flexible when it comes to investing.
Advantage No.4: Roth Conversion Strategy
Another notable advantage of the solo 401(k) is that unlike the SEP IRA, it is not considered when evaluating the pro-rata cost for a Roth conversion.
Advantage No.5: Roth Contribution Allowed in Solo 401(k)
Solo 401(k) allows Roth contributions. The SEP IRA has no such option. If you prefer to pay the taxes but are still interested in maximizing your retirement savings, you can elect to contribute after-tax into a Roth solo 401(k) while the employer contribution is contributed before-tax as a traditional Solo 401(k). These contribution are not subject to Aggregate Gross Income limitations for regular Roth IRA contributions.
Advantage No.6: Higher Retirement Account Balance Over Time
It is also noteworthy that since a higher 401(k) contribution is allowed for each year, the cumulative result compounded by tax differed growth could be a difference of hundreds of thousands of dollars in your retirement plan over your working years and a larger retirement income.
The Bottom Line
In almost all cases, the Solo 401(k) is a better alternative to the SEP IRA for sole proprietors. If you are making contributions to a SEP IRA, you should know that the deadline to open a Solo 401(k) is December 31, as opposed to tax filing for the SEP IRA. If you are a sole proprietor, consider opening up a Solo 401(k) today.
For More Information, Contact:
Jit Tandon (703) 629-2049
Frank Ficadenti (571) 344-2228
* Based on 2015 limits for SEP and 401(k)s
This information is provided as general guidance on the subject covered and in not intended to be authoritative or to provide legal, tax or investment advice.