What You Need to Know
- Solo 401(k)s are limited to business owners and spouses involved in the business. SEP-IRAs can include employees.
- Solo 401(k)s allow employee contributions as well as a Roth option.
- SEP-IRAs can be opened and funded as late as the business tax filing date, including extensions.
You know the importance of having a retirement plan in place for your self-employed clients. Two key plans to consider are the SEP-IRA and the Solo 401(k). Determining the better choice for your client will depend upon their situation.
What Is a SEP-IRA?
SEP stands for simplified employee pension. A SEP-IRA is a type of traditional individual retirement account. SEP-IRA contributions are made only with employer contributions; no employee contributions are allowed.
If there are employees in the business, you must contribute the same percentage of compensation to their accounts as you do for your own. This can get expensive, and for that reason a SEP-IRA may not be the best retirement plan option for a business with employees. It is a solid option for those who are self-employed and don’t have employees in the business, or who only have a small number of employees for whom they are comfortable making contributions.
Benefits of a SEP-IRA
Contributions to a SEP-IRA can be made up to 25% of compensation, including self-employment income, up to a maximum of $58,000 for 2021. This percentage may be lower for a Schedule C taxpayer due to the way the calculation works, however. A SEP-IRA can be opened and funded up to the date that the business tax return is due, including extensions.
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Downsides of a SEP-IRA
One potential downside is that Roth accounts are not available with a SEP-IRA. Since contributions are based on a percentage of income for the year, if your client has a low year in terms of compensation, their ability to contribute for the year will be limited. In addition, plan loans are not available with a SEP-IRA.
What Is a Solo 401(k)?
A Solo 401(k), also known as an individual 401(k), is a retirement plan that is available only to business owners, spouses involved in the business and business partners. Employee contributions are allowed at the same level as a 401(k) through an employer. For 2021, these levels are $19,500 plus a $6,500 catch-up contribution for those 50 or older.
Additionally, employer profit-sharing contributions of up to 25% of compensation can be made. This brings the maximum total contribution to $58,000; the maximum is $64,500 for those who are 50 or older for 2021.
Benefits of a Solo 401(k)
Depending upon the custodian chosen, a Roth option may be available for employee contributions, but not for employer profit-sharing contributions. Likewise, plan loans can be an option. The employee deferral option allows clients to contribute up to the maximum deferral amounts of $19,500 or $26,000 as long as their compensation is at least at these levels.
In comparing the two plans, if the maximum salary deferrals are made the Solo 401(k) can generally be maxed out in terms of total contributions at a lower compensation level than with a SEP-IRA.