Solo-K vs SEP IRA: Choosing the Right Retirement Plan for Self-Employed Individuals
Retirement planning can be daunting, especially if you’re self-employed. With several options at your disposal, it can be challenging to decide which retirement plan suits your needs best. Today, we’re putting two popular retirement accounts head-to-head: Solo-K and SEP IRA. These accounts are especially common in fields like medicine and freelance work, where individuals often have a 1099 income. We’ll highlight the pros, cons, and nuances of each to help you make an informed decision.
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Solo-K (Solo 401k)
What is a Solo-K?
A Solo-K, also known as a Solo 401(k), is a retirement plan designed exclusively for self-employed individuals and small business owners who have no employees. If you’re self-employed or receive 1099 income and have no employees besides possibly your spouse, you’re eligible for a Solo-K. Think of it as a 401(k) plan tailored just for you.
Contribution Limits (2024)
Total Limit: Up to $69,000
Employee Contribution: $23,000
Employer Contribution: Up to $46,000
Catch-Up Contribution (age 50+): $7,500
To simplify, if you look at your Schedule C net profit, you can contribute 20% of that number. There are online calculators to help with these figures. Here is our favorite from Mike Piper: Solo-K Calculator
Pros of Solo-K
Higher Contribution Limits
One of the significant advantages of a Solo-K is the high contribution limits. If you have substantial 1099 income, a Solo-K allows you to stash away a considerable amount pre-tax, which can also be paired with defined benefit plans for even larger contributions. Technically, they both cap out at the same limit ($69,000 for 2024), but it can be easier to get higher amounts saved with the Solo-K.
Tax Deductions
Solo-Ks offer excellent tax benefits. Pre-tax contributions can reduce your taxable income. Additionally, you can split these benefits—employee contributions impact your personal taxes, while employer contributions benefit corporate tax returns. This dual benefit adds considerable value to high earners looking to maximize their tax advantages.
Customization Options
Flexibility is another strong suit of the Solo-K. Whether you’re looking to incorporate Roth contributions, need loan provisions, or want to design a plan that accommodates Mega Backdoor Roth strategies, the Solo-K offers customization. Note that different providers may offer varied features. While Fidelity may not support Roth options via their “cookie-cutter” plans, other providers can but always double-check for the latest details.
Cons of Solo-K
Cannot Have Employees
The most significant limitation of a Solo-K is its inability to include employees other than your spouse. This could be a substantial drawback if you plan to hire employees soon (W2 employees).
Additional Filing Requirements
Once your Solo-K balance exceeds $250,000, you’ll need to file Form 5500-EZ. Filing using an Employer Identification Number (EIN) rather than your Social Security number makes this more straightforward but adds another layer of complexity.
Substantial and Recurring Contributions
The IRS requires that contributions to your Solo-K be “substantial and recurring.” This loosely defined rule requires consistent contributions, usually three out of five years, to avoid the risk of plan termination.
SEP IRA (Simplified Employee Pension)
What is a SEP IRA?
A SEP IRA is another popular retirement plan designed for self-employed individuals and small business owners. Unlike the Solo-K, a SEP IRA allows for contributions to employees’ retirement savings, making it a more inclusive plan.
Contribution Limits
Total Limit: Up to $69,000 or 25% of compensation (2024)
Comparison to Solo-K
While both plans offer the same total contribution limit, they differ in how this limit is calculated. Solo-K allows separate employee and employer contributions, whereas SEP IRA contributions are a uniform percentage of total compensation.
Pros of SEP IRA
High Contribution Limits
Just like the Solo-K, a SEP IRA allows for significant contributions. The magic number here is $276,000 (2024), which allows for a maximum contribution of 25% of your compensation.
Flexibility in Contributions
SEP IRAs offer more flexibility when it comes to contributions. Adjusting contributions based on business performance is easier, and you can also decide to contribute nothing in a bad year.
Simpler Setup Process
Opening a SEP IRA is straightforward and quick. You can easily set one up with major providers like Vanguard and Fidelity, making it an attractive option for those who need to establish a plan quickly, especially near tax deadlines.
Employee Benefits
SEP IRAs can be an enticing employee benefit, providing immediate ownership of contributions without a vesting schedule. This can attract and retain quality talent.
Cons of SEP IRA
Uniform Contribution Requirement
One significant drawback of a SEP IRA is the uniform contribution requirement. If you contribute 25% of your compensation, you must contribute the same percentage for all eligible employees, which can be costly.
No Employee Contributions
Employees cannot make their own contributions to a SEP IRA, which limits their ability to save.
No Catch-Up Contributions for Those Over 50
Unlike the Solo-K, SEP IRAs do not offer catch-up contributions for those over 50, limiting additional savings opportunities for older savers.
No Loan Options
SEP IRAs do not provide for loans against the plan, which could be a disadvantage if you need emergency funds.
Higher Income Requirement to Max Out Contributions
You need to have substantial income—at least $264,000 annually—to maximize contributions, making it less suitable for those with lower incomes.
Comparison: Solo-K vs SEP IRA
Impact on Backdoor Roth IRA
One of the most significant distinctions is how each plan affects the backdoor Roth IRA strategy. Solo-K does not affect this strategy, making it a superior option if this is part of your financial plan. In contrast, SEP IRA contributions can disrupt your backdoor Roth strategy.
Contribution Calculation Differences
Solo-K’s separate employee and employer contributions offer more flexibility and higher potential savings compared to SEP IRA’s uniform percentage calculation.
Employee Considerations
While Solo-K is limited to those without employees (except a spouse), SEP IRA allows for employee contributions, which can be a deciding factor if you plan to hire.
Flexibility in Plan Design
Solo-K offers more customization options, while SEP IRA provides a more straightforward approach but with less flexibility.
Choosing Between Solo-K and SEP IRA
Factors to Consider
When choosing between Solo-K and SEP IRA, consider these factors:
- Current Income Level: Higher income levels may benefit more from a Solo-K due to higher contribution limits.
- Future Employment Plans: If you plan to hire employees, a SEP IRA may be more suitable.
- Backdoor Roth IRA Strategy: Solo-K is the clear winner if you plan to make backdoor Roth IRA contributions.
- Tax Situation: Solo-K may offer more tax benefits, especially if you can split contributions between personal and corporate tax returns.
Potential for Combining or Converting Plans
If your financial situation changes, you can often roll a SEP IRA into a Solo-K or other 401(k) plans, offering flexibility to adapt to new circumstances.
Additional Retirement Plan Options
While Solo-K and SEP IRA are both excellent choices, other retirement plans like Traditional 401(k) and SIMPLE IRA may also be worth considering, depending on your specific needs and circumstances.
Setting Up a Solo-K
Steps to Establish the Plan
- Choose a provider (Fidelity, Vanguard (Leaving Solo-K space), Schwab)
- Decide on customization options (Roth contributions, loan provisions)
- Complete necessary paperwork and establish the plan before the year-end
Customization Options
Consider whether you’ll need Roth contributions, loan provisions, or integration with a defined benefit plan. Make sure your chosen provider supports these features.
Setting Up a SEP IRA
Steps to Establish the Plan
- Choose a provider (Vanguard, Fidelity, Schwab)
- Open the account, usually a quick process
- Make contributions based on 25% of compensation
Deadlines and Contribution Timing
SEP IRAs offer more flexibility with deadlines and can often be set up quickly, making them ideal for last-minute tax benefits.
Tax Implications
Solo-K Tax Benefits
- Personal Tax Return Benefits: Employee contributions reduce taxable income.
- Corporate Tax Return Benefits: Employer contributions benefit corporate taxes.
SEP IRA Tax Benefits
SEP IRA contributions are tax-deductible, reducing taxable income.
Maintenance and Compliance
Solo-K Requirements
- Annual filing requirements once the balance exceeds $250,000
- “Substantial and recurring” contributions to avoid plan termination
SEP IRA Requirements
- Uniform contribution for all eligible employees
- No annual filing requirement simplifies maintenance
Future Considerations
Stay informed about potential changes in tax laws and IRS focus areas, as these can impact your chosen retirement plan.
Common Mistakes to Avoid
Solo-K Mistakes
- Failing to file Form 5500-EZ when required (Balance over $250,000)
- Not making consistent contributions
SEP IRA Mistakes
- Not planning for the uniform contribution requirement
- Assuming employees can contribute
Conclusion
Both Solo-K and SEP IRA are excellent retirement plans with distinct advantages and disadvantages. Your choice will depend on your income level, future employment plans, and tax strategy. By understanding the pros and cons of each, you can make an informed decision that best suits your retirement planning needs.
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