- The Solo 401(k) is best for almost everyone
- A SEP IRA is a pure profit sharing plan
- Choosing your retirement goals can help you reach them
One of the most common questions small business owners have when it comes to establishing a retirement plan for their business is whether they should set-up a SEP IRA or a Solo 401(k) plan. In 2022, the answer is just as clear as past years. The Solo 401(k) plan beats the SEP IRA in almost every case. Below is a breakdown of the key advantages of a Solo 401(k) plan versus a SEP IRA for the 2022 taxable year.
What is a SEP IRA?
A Simplified Employee Pension Individual Retirement Arrangement (SEP IRA) has traditionally been the most popular retirement plan for the self-employed and small business owner A SEP IRA is a pure profit sharing plan that allows the employer to male up to a 25% (20% in the case of a sole proprietorship of single member LLC) profit sharing contribution to all eligible employees up to a maximum of $61,000 for 2022 or $58,000 for 2021. A SEP IRA does not include a catch-up contribution option for those over the age of 50. Also, a SEP IRA is a pure profit sharing plan that dos not include any employee deferrals. In addition, all SEP IRA contributions must be made in pre-tax.
What is a Solo 401(k)?
A Solo 401(k) plan is an IRS approved retirement plan, which is suited for business owners who do not have any employees, other than themselves and perhaps their spouse. The Solo 401(k) Plan is not a new type of plan. It is essentially a regular 401(k) plan covering only one employee. The Economic Growth Tax Relief and Reconciliation Act of 2001 (EGTRRA) created a strong interest in the Solo 401(k) Plan. EGTRRA added employee deferrals, the loan feature, and Roth contributions to the Solo 401(k) plan making it a far better option for the self-employed or small business owner than a SEP IRA.
What types of business entities are best when using a Solo 401(k)?
The Solo 401(k) plan may be adopted by an individual sole proprietor, or any other business entity, such as an LLC, corporation, or partnership. In general, in order to be eligible to benefit from the Solo 401(k) Plan, one must meet just two eligibility requirements:
(i) The presence of self-employment activity.
(ii) The absence of full-time employees.
The following types of employees may be generally excluded from coverage:
- Employees under 21 years of age
- Employees that work less than a 1000 hours annually
- Union employees
- Nonresident alien employees
In sum, so long as the individual has a business, which can be a sole proprietorship or any entity, and the business has no full-time employees other than the owner or spouse (not treated as an employee under ERISA), the business is eligible to adopt a Solo 401(k) plan.
Who benefits most from using a Solo 401k?
Any sole proprietor or small business owner that wishes to make high annual tax-deferred or Roth contributions, would benefit greatly from establishing a Solo 401k). Under the 2022 Solo 401(k) contribution rules, a plan participant under the age of 50 can make a maximum annual employee deferral contribution in the amount of $20,500 ($19.500 for 2021). That amount can be made in pre-tax, after-tax or Roth. On the profit-sharing side, the business can make a 25% (20% in the case of a sole proprietorship or single member LLC) annual profit-sharing contribution based on the amount of the net Schedule C amount or W-2, as applicable, up to a combined maximum, including the employee deferral, of $61,000, an increase of $3,000 from 2021.
For plan participants over the age of 50, an individual can make a maximum annual employee deferral contribution in the amount of $27,000. That amount can be made in pre-tax, after tax, or Roth. On the profit-sharing side, the business can make a 25% (20% in the case of a sole proprietorship or single member LLC) annual profit sharing contribution based on the amount of the net Schedule C amount or W-2, as applicable, up to a combined maximum, including the employee deferral, of $67,500, an increase of $3,000 from 2021.
In the case of a SEP IRA, only employer profit sharing contributions are permitted. For example, on the profit-sharing side, the business can make a 25% (20% in the case of a sole proprietorship or single member LLC) annual profit-sharing contribution based on the amount of the net Schedule C amount or W-2, as applicable, up to a combined maximum amount of $61,000. Plus, a SEP IRA has no catch-up contribution option for taxpayers over the age of 50.
Below are several examples illustrating how the solo 401(k) plan and SEP IRA contribution rules work.
Example 1: Amy is 45 years old and has a sole proprietorship business. Amy earned $60,000 of net Schedule C income in 2022. If Amy wished to maximize her contributions to her solo 401(k) plan she could make $20,500 employee deferrals, in pre-tax or Roth, plus 20% of $60,000 or $12,000 giving her a total $32,500 of solo 401(k) contributions in 2022. Whereas, if Amy had set-up a SEP IRA, she would be limited to 20% of $60,000 or $12,000.
Example 2. Same facts as Example 1, but let’s assume Amy is 55 years old. Amy earned $60,000 of net Schedule C income in 2022. If Amy wished to maximize her contributions to her solo 401(k) plan she could make $27,000 employee deferrals, in pre-tax or Roth, plus 20% of $60,000 or $12,000 giving her a total $39,000 of solo 401(k) contributions in 2022. Whereas, if Amy had set-up a SEP IRA, she would be limited to 20% of $60,000 or $12,000.
Example 3. Mike is 42 years old and has a business set-up as a S corporation. Assume Mike earns $100,000 of W-2 income for 2022. If Mike wished to maximize his contributions to his solo 401(k) plan he could make $20,500 employee deferrals, in pre-tax or Roth, plus 20% of $100,000 or $20,000 giving him a total $40,500 of solo 401(k) contributions in 2022. Whereas, if Mike had set-up a SEP IRA, he would be limited to 20% of $100,000 or $20,000.
Example 4. Same facts as Example 3, but let’s assume Mike earned $500,000 of W-2 income in 2022. . If Mike wished to maximize his contributions to his solo 401(k) plan he could make $27,000 employee deferrals, in pre-tax or Roth, plus 20% of $500,000 or $100,000. However, since his maximum contribution would exceed the $61,000 maximum contribution threshold, Mike would be limited to $61,000 as a maximum contribution amount for 2022. Whereas, if Mike had set-up a SEP IRA, he would be limited to 20% of $500,000 or $100,000. However, like the solo 401(k), Mike SEP IRA contribution maximum would be limited to $61,000. In sum, this scenarios is basically the only time would select a SEP IRA over a solo 401(k) plan, since in both plans, the contribution maximum would be reached and Mike is not eligible for any catch-up contributions, which is not available in a SEP IRA.
401(k) Loan Option
With a Solo 401(k) plan you can borrow up to $50,000 or 50% of your account value, whichever is less. The loan can be used for any purpose. The solo 401(k) loan must be paid back at least quarterly over a five year period. The lowest interest rate allowed for the loan is the Prime interest rate, which is 5.50% as of August 30, 2022. Whereas, with a SEP IRA, the IRA holder is not permitted to borrow even $1 dollar from the IRA without triggering a prohibited transaction.
Roth Contribution Option
A Solo 401(k) plan, employee deferrals of $20,500 or $27,000 if over the age of 50 for 2022 can be made in pretax, after-tax or Roth format. Whereas, in the case of a SEP IRA, contributions can only be made in pretax format. SEP IRA contributions can then be converted to a Roth IRA, but the initial SEP IRA contribution must be in pretax.
Self-Directed Investment Options
Both the SEP IRA and the solo 401(k) plan allow one to make traditional investments, such as stocks, but also alternative asset investments, such as real estate or even cryptocurrencies. The only difference between a SEP IRA and a solo 401(k) plan from an investment standpoint is that a solo 401(k) plan can buy life insurance and a 401(k) plan is exempted from the unrelated business taxable income (UBTI) tax for nonrecourse leverage used for a real estate acquisition project.
Nonrecourse Leverage to Buy Real Estate
With a Solo 401(k) Plan, you can make a real estate investment using a nonrecourse loan without triggering the Unrelated Debt Financed Income Rules and the Unrelated Business Taxable Income (UBTI or UBIT) tax (Internal Revenue Code Section 514). However, the nonrecourse leverage exception found in Internal Revenue Code Section 514(c)(9) is only applicable to 401(k) qualified retirement plans and does not apply to IRAs. In other words, using a Self-Directed SEP IRA to make a real estate investment involving nonrecourse financing would trigger the UBTI tax, which could be close to 37 percent on a portion of the net income associated with the nonrecourse loan.
Administration
Possibly the one area where the SEP IRA would prove superior to the solo 401(k) plan is the area of administration. In the case of a SEP IRA, the IRA custodian that holders the SEP IRA is required to file all IRS forms, including Form 5498 and 1099-R. Whereas, in the case of a solo 401(k) plan, IRS Form 5500-EZ must be completed by the plan administrator (you), if the plan’s assets exceed $250,000 as of December 31 of the previous year. The good news is that if you are a client of IRA Financial, we will assist you with the filing of the Form 5500-EZ, if applicable.
Final Thoughts
Overall, it is still surprising that so many SEP IRAs are being established and maintained by the self-employed in light of the many advantages of a Solo 401(k) plan. In addition, the 2019 SECURE Act now allows one to establish a Solo 401(k) plan for the previous year up until the employer files the business return. Thus, there is almost no smart reason to elect to establish a SEP IRA over a Solo 401(k) plan.
