One of the most common questions I see from new entrepreneurs is about their retirement plan options. Specifically, I see a lot of people talking about the Solo 401k vs SEP IRA. Today I’m going to explain what those two plans are, show you the differences, and share why I chose the Solo 401k.
In short, I find that the SEP IRA is the perfect tool for the part-time entrepreneur (someone who has a small business, but is still eligible for a 401k through their full-time employer). The Solo 401k, on the other hand, is great for anyone who is fully self-employed in a one-person business.
But there is obviously more to it than that. We need to look at the tax and administrative differences, in both the short and long terms. Let’s dig into each of these accounts first so you can fully understand the differences.
The Solo 401k
The Solo 401k is just what it sounds like: a 401k plan (i.e. tax-deferred retirement plan) for an individual. The individual’s business cannot have employees other than an employed spouse. The owner’s spouse can participate in the Solo 401k if an employee of the business.
In many ways, the Solo 401k acts just like a regular 401k you would get through an employer. Contributions to a Solo 401k are not taxed (i.e. they help reduce taxable income) when they are contributed. Money can be withdrawn from the Solo 401k without penalty in retirement (at age 59.5), when regular income taxes will be paid on the money withdrawn.
Depending on the provider of the plan, you might be able to borrow money from your Solo 401k, up to $50,000 or 50% of the value, whichever is less. And many providers will allow you to choose from a wide variety of investments options (cash, CDs, stocks, bonds, funds, etc.) within your 401k.
But the Solo 401k has it’s unique qualities as well. Because you are both the employer and the employee in your business, you can contribute both the employer’s and the employee’s (salary deferral) portions to the Solo 401k.
The employee’s contribution limits fall in line with regular 401k limits, which are $17,500 for 2013. Note that these contributions are shared with any other 401k contributions you are making.
The employer’s contribution limits are set at 25% (or 20% if a sole proprietor or single-member LLC) of the compensation you pay yourself, up to a total contribution (including the employee’s portion) of $51,000 in 2013.
A Solo 401k must be established prior to year end to make contributions for that year.
A special feature I’m just learning about is the ability to take some of the employee’s contribution and designate it as a Solo Roth 401k contribution. I’m not sure of how many providers will allow this, but it’s certainly another advantage of the Solo 401k if possible for you.
The SEP IRA
The Simplified Employee Pension Individual Retirement Arrangement (SEP IRA) is very similar to a traditional IRA. A business owner with or without employees can establish a SEP IRA.
Contributions to a SEP IRA are deductible and grow tax deferred until retirement (at age 59.5), when regular income taxes will be paid on the money withdrawn. You cannot borrow from a SEP IRA. Most SEP IRA providers will allow you to pick from a big menu of investment options to have within your SEP IRA.
There is no employee deferral contribution to a SEP IRA. All of the contributions must come from the employer. Still, the maximum contribution is the same as the Solo 401k: 25% of compensation, up to $51,000 for 2013.
A SEP IRA must be established before the tax deadline to make contribution for that previous year.
Other Small Business Retirement Plans
These are not the only two retirement plans available to small business owners. Although they are very common. Others include the SIMPLE IRA plan, regular 401k, or a regular Roth or traditional IRA. Be sure to sit down with a CPA or other professional to determine which particular plan is right for you.
Why I Choose a Solo 401k vs SEP IRA
Ultimately I chose a Solo 401k because I was no longer employed by someone else and I didn’t have access to a regular 401k. I missed being able to defer tens of thousands of dollars in income each year. If I was still employed by someone else and working on my business part-time I would likely use a SEP IRA.
I also liked that I could add my wife to the plan at some point, which I’ve done since. Mostly I liked that I could contribute as an employer and an employee for a really large contribution.
Lastly, I would say that I liked that Vanguard offered an easy-to-setup Solo 401k plan that was fee-free for me since I’m at their Voyager service level. Here’s what some others had to say:
What about you? Which plan do you think is right for you? If you already have a plan, which plan do you use and why?