By Sundack CPA | Reading Time: 4 minutes
If you are an independent contractor or a Small Business with only yourself (or yourself and your spouse) as the employee, this article is for you.
First, lets understand the benefit that both of these plans give you:
- Create tax deduction today when you are in your peak lifetime earnings
- Monies grow tax-deferred inside of the plan
- Pay tax only when you withdraw funds from the plan
SEP- IRA
Simplified Employee Pension Individual Retirement Arrangements, or SEP-IRAs, are a good fit for a small business owner with few to no employees other than the Owner OR the self-employed. A sole proprietor under 50 can shelter 20% of net business profit, up to a total contribution of $58,000 for 2021. An S-Corporation can contribute up to 25% of the compensation maxed out at $58,000.
The amount that you place in this tax deferred account is 100% tax deductible. For instance, if you are in a 28% Federal Tax Rate and 6% State Tax Rate, a $10,000 could potentially save you $3,400 in tax, thereby making these contributions an additional $6,600 in cash outlay because you were going to pay the tax of $3,400 anyway. So the government is incentivizing you to save for retirement by giving you this tax deduction.
A SEP-IRA can be set up online with most banks and brokerage companies and you have the ability to invest the money as you see fit. The underlying paperwork to open a SEP is simple and can be accomplished in under 10 minutes with most financial institutions.
You have until your tax due date including extensions to fund the plan. So for a personal tax return if you timely file an extension, you would have until October 15th of the following year to contribute. For a Calendar year Partnership or S-Corporation, you would have until September 15th of the following year.
SOLO 401(k)
Solo 401(K)s can only be open if your business has NO employees other than your spouse. For 2021, the maximum “employee” contribution is $19,500 (or $26,000 if you are age 50 or over). However, the law allows for the business to fund the plan with an employer contribution which is equal to 25% of the compensation, maxed out at $58,000 for 2021, just like the SEP plan above.
The paperwork to open a Solo 401(K) is a little more complicated than the SEP, however, we can help you with that. The plan needs to be opened by the end of the calendar year and the employee contributions need to funded by the end of the calendar year as well. You have until the extended due date fund the Employer Contributions. When the plan accumulates more than $250,000, a separate tax filing will be required (Form 5500).
ADVANTAGES OF A SOLO 401(K) OVER A SEP-IRA
- Preserving the 199A Deduction– Employee contributions do not factor against the 199A deduction, where contributions to your SEP-IRA would
- Catch up Contributions– the Solo 401(K) allows you to put away an additional $6,500 if over 50, the SEP does not
- Roth Contributions– you may make Roth contributions to your Solo 401(K)- Note these contributions would not be tax deductible
- Back Door Roth– by keeping your retirement money inside of a Solo 401(K) you can still preserve your ability to contribute to a Roth IRA via the Backdoor. With a SEP, some of your contribution could be taxable
- Mega Back Door Roth– These are after tax contributions with either in plan Roth Conversions or In Service Withdrawals with a conversion to a Roth IRA.
- Loans– You can borrow money from a Solo 401(K), you can not from a SEP-IRA
- Higher Allowable Contributions– Only for Sole Proprietors as you would only need $192,500 to max out a Solo 401(K) in 2021, but would need $290,000 to max out a SEP-IRA
Too much information? As you can see, this is not a simple decision. The short cut?? Ask us! We are here to advise you which plan would best benefit you and your business. Every business owner has different goals. We sit down with our clients and walk them through every scenario to come up with the plan that best matches their specific goals. Click here to get started.
