As a self-employed individual or business owner you have a few different ways to save for your retirement. The primary retirement savings plan option for self-employed individuals are Solo 401(k)s, and for small business owners are SEP IRAs, but that does not mean you are required to use one over the other. In some cases, a SEP IRA may make the most sense for a self-employed individual, while a Solo 401(k) may be the best option for a small business owner who meets the requirements. While these two options have many similarities, understanding the differences can have a significant impact on the amount you are able to save towards retirement.
A Solo 401(k), also known as an Individual 401(k), is a qualified retirement plan for business owners who have no full-time employees, other than a spouse that also is employed by the business. Both Traditional (pre-tax) and Roth options are available.
As both the business owner and employee, you are eligible to make contributions as an employee and as the employer. Employee contributions can be made up to the current annual contribution limit ($19,000 in 2019, plus $6,000 if you are over age 50). Contributions can be made up to 100% of compensation.
Employer contributions cannot exceed 25% of the employee’s net compensation. Total contributions from all sources (employee + employer) cannot exceed $56,000 for 2019 if you are under age 50, and $62,000 if you are age 50 or older. The additional allowable contributions after age 50 are called “catch-up contributions.”
Solo 401(k)s do not have age or income restrictions for eligibility. These plans must be established, and employee contributions made by the end of the calendar year. Employer contributions can be made up to the tax filing deadline, including extensions. There are no filing requirements until the plan balance reaches $250,000.
See example in the section “Case Study”
A Simplified Employee Pension (“SEP”) IRA is a type of retirement plan that is primarily used by small business owners or self-employed individuals, although they are available to any size business. SEP IRAs are relatively simple to establish and maintain. No Roth option is available with SEP IRAs.
Unlike Solo 401(k)s, SEP IRAs are funded through employer contributions only. Contributions do not need to be made every year, but when made, each eligible employee must receive a contribution that is an equal percentage of compensation as the owner makes to his or her own plan. In the case of a self-employed individual, that person would be the sole employee. The business would make contributions for the owner, up to the maximum allowable amount each year. Contributions are tax-deductible to the business.
Contribution limits for SEP IRAs are limited to the lesser of 25% of the employee’s compensation, or $56,000 (in 2019). Catch-up contributions are not allowed.
SEP IRAs do have eligibility requirements, which apply not only to employees of a small business, but also to self-employed individuals. An employee is considered to be eligible if he or she is over age 21, has worked for the business for at least 3 of the past 5 years, and has earned a minimum of $600 in compensation for the year. The employer may choose to use less restrictive eligibility requirements, but not more restrictive. These plans can be established, and contributions made for a given year at any point prior to the business’s tax-filing deadline, including extensions.
See example in the section “Case Study”
Which One Should I Choose?
When determining which option is right for you, there are multiple variables to consider. Some of the questions to think about are:
- Do you have employees, or do you expect to hire employees in the future?
- Does your business consistently generate enough revenue for you to make employer contributions for yourself as well as your employees, or would you require more flexibility?
- How concerned are you about the expenses associated with setting up and maintaining a retirement plan?
- Is it important for you to have both Traditional and Roth savings options for yourself and/or your employees?
Case Study: Consulting After Career
- Following a corporate career, an individual sets up her own consulting business.
- Individual is age 60, single, and net business income is $100,000 per year.
- The consulting business income is not needed for living expenses, due to other income sources.
- The goal is to maximize pre-tax savings for the consulting income.
Plan Type Employee Contribution Employer Contribution Total
SEP IRA Not allowed $25,000* $25,000
Solo 401(k) $19,000 + $6,000** $16,983.56** $41,983.56
In this case the Solo 401(k) would allow for $16,983.56 more in pre-tax savings (or 68% more in pre-tax savings) due to the allowed employee contribution.****
Which retirement savings plan is best for you will be highly dependent on your unique situation. In many cases, it may be worth considering a Solo 401(k). In conjunction with your tax professional, your Freestone Client Advisor can help you make the best choice for your circumstances.
Footnotes from Case Study: Consulting After Career
*$100,000 annual compensation x 25%, or $25,000
**$100,000 annual compensation, over age 50, allows for a $19,000 contribution and a $6,000 catch-up contribution, or $25,000 of employee contributions
***$100,000 annual compensation – $25,000 employee contribution – $7,065.78 half of self-employment taxes = $67,934.22 of net compensation x 25% = $16,983.56
****Estimates only. Actual calculations and resulting recommendations may vary dependent upon personal situation.
Important Disclosures: Nothing in this document is intended to provide, and you should not rely upon it for, accounting, legal, tax, retirement or investment advice or recommendations. We are not making any specific recommendations regarding any retirement savings strategies, and you should not make any retirement savings plan decisions based on the information in this document. The intention of this document is educational, and it is intended only to discuss limited aspects of retirement savings plans in general terms. This document is not a comprehensive or complete summary of considerations regarding retirement savings plans. Each individual is in a different situation and has different items to address, and the options in this document are not appropriate for everyone. Please consult your Freestone client advisor regarding options specific to your needs.