Strategic retirement planning is crucial, especially for small business proprietors, independent contractors, and the self-employed to ensure a comfortable retirement. Just like you manage your business, you are also responsible for your retirement.
However, it can be challenging for small business owners to establish a retirement plan. This requires time, the right tools, and most importantly the knowledge to choose the right one. The pandemic has presented additional challenges, as many small business owners continue to struggle to retain and motivate employees, which, in turn, hinders both business growth and retirement savings. It’s not surprising that a significant one-third of small business owners lack a retirement savings plan and confidence in retiring by age 65.
In this article, we will explore two popular retirement plans tailored for small businesses, delving into their distinctive features, and showing you how to get started with minimal overhead.
Comparing Solo 401(k)s and SEP IRAs
Solo 401(k)s and SEP IRAs are popular plans because they are quicker to establish, less expensive, and easier to manage compared to conventional 401(k)s. This makes them a good choice for smaller businesses. To establish any one of these plans, you must have an established business.
While both are tailored for small business owners, these plans exhibit distinct characteristics. Although the IRS regulates both, there are still some differences between them. Let’s get into the key differences to help you decide the optimal retirement savings plan for your needs.
Main Difference Between Solo 401(k) and SEP IRA
Who is it for?
The Solo 401(k) caters to business owners with no full-time employees other than themselves or their spouses.
A SEP IRA suits self-employed individuals and small business owners, of any size with employees.
Generally, eligibility for participation in a SEP IRA is quite inclusive, and even if you have just one employee, you are generally required to include all eligible employees in the plan. An eligible employee is defined as someone who:
Is at least 21 years old.
Has worked for the employer in at least three of the last five years.
Has received at least $750 in compensation from the employer in the current year, for 2024 and 2023, and $650 in 2021 and 2022.
So, if your employees meet these criteria, they must be included in the SEP IRA plan.
Who Makes the Contributions?
SEP IRA Contributions
In a SEP IRA, the contributions are made by an employer. It's important to note that employer contributions made under a SEP plan do not affect the amount you can contribute to an IRA on your own behalf.
Since a SEP IRA is a type of Traditional IRA, you may be able to make regular annual IRA contributions to this account, which eliminates the need to open a separate Traditional IRA.
Thanks to Section 601 of SECURE Act 2.0, starting January 1, 2023, you can now designate your employer profit-sharing contributions as a Roth IRA. However, it's important to note that the IRS guidance on these accounts is still unclear, according to tax professionals and financial advisors. Additionally, custodians are working on updating their agreements to include Roth language, so this option may not be immediately available. Stay tuned for further updates!
Solo 401(k) Contributions
When it comes to contributing to a Solo 401(k), the business owner plays two roles: employee and employer. This allows for contributions to be made to the plan in both capacities.
One of the great advantages of this plan is the inclusion of a Roth IRA component, which enables tax-free growth. However, it's important to note that not all providers offer this feature, so it's crucial to thoroughly research the plan's features if this is something you require.
Maximum Contribution Limits
For those under 50, the combined total of employee and employer contributions for Solo 401(k) plans is $66,000 for 2023 and $69,000 for 2024. Additionally, the maximum employee deferral is $22,500 for 2023 and $23,000 for 2024. For those 50 or over, Solo 401(k) plans allow for additional catch-up contributions of $7,500 for 2023 and 2024.
Similarly, SEP IRAs offer high contribution limits compared to other IRA plans, with up to 25% of compensation or $66,000 annually for 2023 and $69,000 for 2024. However, the maximum allowed with a Solo 401(k) plan is even greater because you have the employee contribution.
It's important to note that contributions for any retirement plan are limited to self-employment income, and required minimum distributions kick in at age 73 (starting in 2023), becoming taxable income. Therefore, carefully weighing the pros and cons will help you make an informed decision aligned with your financial goals and circumstances.
Considerations for Solo 401(k)
A Solo 401(k) retirement plan is perfect for self-employed individuals or those with a spouse as their only employee. With this option, you have the benefit of higher contribution limits compared to a SEP IRA because you can make contributions as both the employee and employer.
It's important to consider your current and future tax situations when deciding between pre-tax and post-tax contributions to your solo 401(k). A solo 401(k) can be funded with pre- or post-tax dollars. A pre-tax solo 401(k) contribution allows you to reduce your taxable income in the year the contribution is made. You won't pay taxes on the contributed amount until you withdraw it in retirement.
On the other hand, a post-tax Solo 401(k) contribution, also known as a Roth contribution, is made with after-tax dollars. The tax break on this account type isn't immediate. However, with post-tax dollars through a Roth 401(k), your investment earnings and qualified withdrawals in retirement are tax-free.
You can also borrow from your Solo 401(k). If you're inclined to borrow from your Solo 401(k), keep in mind that the maximum loan is the lesser of 50% of your vested balance or $50,000. To avoid default, make sure to pay back the loan at least quarterly. Note that loan offset can be rolled over, but it is not advisable to borrow from your Designated Roth and After-tax accounts. This option is only available for Solo 401(k) plans, borrowing from a SEP IRA is not permissible.
Solo 401(k)s are also exempt from unrelated debt-financed income (UDFI)
When a self-directed IRA buys real estate using a non-recourse loan or mortgage, it creates UDFI – a type of income that is taxable. With a Solo 401(k) plan, you can use a non-recourse loan without being subject to the UDFI rules. This provides significant tax advantages over an IRA to purchase real estate.
Considerations for SEP IRA
All eligible employees, including the business owner, must receive the same percentage of employer-funded contributions. Before committing to a SEP IRA, it is important to consider the potential downsides of this retirement account. First, contribution limits are entirely employer-funded. This means that you, as the employer, must contribute the same percentage to all eligible employees' accounts, including your own. If you have a lot of employees, this can increase quickly and may not be financially feasible.
However, you aren’t required to make contributions every year. For example, if your business is struggling financially, as many small businesses did during the COVID-19 pandemic, you can reduce or even suspend SEP IRA contributions without penalty.
Finally, the SEP IRA does not offer catch-up contributions for those 50 and older.
Which Should I Choose?
Choosing between Solo 401(k) and SEP IRA depends on your business, income, and desired retirement savings contributions. The SEP IRA is ideal for those with employees, offering higher contribution limits and tax-deductible contributions than regular IRAs.
On the other hand, the Solo 401(k) suits those without employees, featuring even higher contribution limits, flexibility in pre-tax or post-tax contributions, and the ability for both employer and employee contributions.
Before deciding, weigh the pros and cons and consult with a financial advisor or tax professional for personalized guidance.
Schedule a Free Consultation with IRAR Today
Whether you choose a SEP IRA or Solo 401(k), the provider of your retirement plan plays a pivotal role.
IRAR, with nearly 30 years of experience, focuses on helping investors build their retirement wealth by providing alternative investment options with low fees. Reach out for a free consultation to build your dream portfolio and secure a financially free retirement.