For those who are self-employed it’s critical that you fund a retirement plan for yourself. Two of the best options are a SEP-IRA and a solo 401(k). As we reach the midpoint in 2022 it’s important to have a retirement plan option in place for yourself. Let’s take a look at the features and benefits of each plan.
A solo 401(k) is a retirement plan that is available for business owners, a spouse who is involved in the business as well as any partners in the business. Nonowner employees are not eligible to participate in the plan. Solo 401(k) planss are also known as individual 401(k)s and as a self-employed 401(k).
Employee contributions are the same as with a 401(k) offered by an employer, $20,500 plus a catch-up contribution of $6,500 for those who are aged 50 or over for 2022. Additionally, the employer can make profit-sharing contributions of the lesser of 25% of the employee’s compensation up to a maximum combined contribution of $61,000 or $67,500 for those who are 50 or over.
Solo 401(k)s can be offered as both a traditional 401(k) and a Roth 401(k). Plan loans may be offered as well. A solo 401(k) must be in place by the final day of the year in order for contributions to count for the year, for 2022 this would be Dec. 31, 2022.
Most major brokers and custodians offer the option to open a solo 401(k) account. The money in the account can be invested in virtually any type of investment vehicle offered by the custodian. This might include individual stocks and bonds, ETFs and mutual funds.
Some advantages of a solo 401(k):
As long as you have earned income you can fund the plan. You can generally contribute as much as 100% of your earned income to the 401(k) portion up to the annual contribution limits. This may allow larger contributions in years where your income is lower than with a SEP-IRA.
The availability of a Roth option for the 401(k) contributory portion of the plan provides added flexibility for those who want to make larger Roth contributions.
Disadvantages of a solo 401(k):
The plan must be established by Dec. 31 of the calendar year for which you want to make contributions. Contributions can be made after that, check with your tax professional to determine the due dates for employee and employer contributions.
A solo 401(k) is not an appropriate small-business retirement plan for a company with nonowner employees.
SEP is short for simplified employee pension. A SEP-IRA is a retirement plan that allows both business owners and employees to participate. Contributions are made by the employer, no individual contributions are allowed. SARSEPs are a version of a SEP-IRA that allows employers to make contributions as deferrals from an employee’s salary. SARSEPs have not been allowed to be established since after 1996 due to a change in the rules governing them. SARSEPs established prior to this time are grandfathered and contributions can continue.
A SEP-IRA can be opened by the tax filing date for the business, including any extensions. Contributions for the prior calendar year can also be made by this date. The maximum contribution for 2022 is 25% of the employee’s compensation up to a maximum of $61,000. The percentage limit may be lower for those who are sole proprietors and file a Schedule C as part of their tax return. This should be discussed with your tax professional.
Unlike a solo 401(k), a SEP-IRA does not allow for a Roth option and there can be no loans made against your plan balance.
Advantages of a SEP-IRA:
The plan can be established and contributions made for the tax year up to the business tax filing date, including extensions.
Employees can participate in the plan.
Disadvantages of a SEP-IRA:
If your income is low in a particular year this will limit your ability to contribute.
There is no Roth option available for a SEP-IRA.
If employees do participate in the plan, they must receive the same percentage of their compensation as a contribution as the business owner. This can become expensive.
Investing in alternative assets
Generally most custodians will not allow many alternative assets to be held in either type of plan. These might include:
Investment real estate
Tax lien certificates
These types of alternative investments and a host of others can typically only be held in a self-directed Solo 401(k) or SEP-IRA. There are a number of self-directed retirement account platforms that offer the ability to open retirement accounts and hold alternatives in your retirement accounts.
A brief comparison
This chart provides a brief comparison of some of the key features of the solo 401(k) versus the SEP-IRA.
Employee contributions permitted
Yes, if plan allows
Roth option allowed
Maximum total contributions for 2022
$61,000 or $67,500 for savers over age 50
$61,000 regardless of age
Deadline to start plan for current tax year
Tax filing date including extensions
If you are self-employed it is important to establish a retirement plan for your business to allow you to accumulate a retirement nest egg. Both the solo 401(k) and the SEP-IRA are good options. It can pay to consult with a financial or tax adviser to determine which type of self-employed retirement option is best for your situation.