Sep-IRA vs Solo 401K
If you work as an independent contractor, meaning you get a Form 1099 each pay period instead of a W-2, you’re responsible for your own benefits, including a retirement plan. Your two main choices are a SEP-IRA or a Solo 401K. This post will help you decide which to use.
Simplified Employee Pension Individual Retirement Arrangements, or SEP-IRAs allow a sole proprietor to shelter 20% (actually 18.6%, at least until you max out your payroll tax) of your business profit up to $49,000 per year ($50,000 if over 50). The amount placed into a SEP-IRA is 100% tax-deductible. You take this deduction on line 28 of the Form 1040. Whatever amount you put into the SEP-IRA is simply put onto line 28 and becomes an “above the line” (the line is line 38-adjusted gross income) deduction. A SEP-IRA can easily be set up on line with most major brokerage companies, such as Vanguard and funded with a simple electronic funds transfer from your personal or business account. It took me less than 5 minutes. This simplicity is the main advantage over a solo 401K.
Solo or Individual 401Ks were introduced in 2002. Rather than limiting contributions to the usual amount of an employee 401K deferral (currently $16,500 per year), the laws allow you to also put in an employer contribution (really all the same money for a sole proprietor), for a total of up to $49,000 per year, exactly the same as a SEP-IRA. A solo 401K, however, is a more complex beast than a SEP-IRA. You are required to have a plan document, for instance. This isn’t a big deal, and the paperwork at most brokerage options walks you through it quickly, but it will take longer than 5 minutes. With that complexity, however, comes a number of options not available in a SEP-IRA.
Advantages of Solo 401K over a SEP-IRA
1) Higher allowable contributions for those making less than $254,460 per year. It turns out you only need $170,840 in income to max out a Solo 401K, but need more than $80,000 more in income to max out a SEP-IRA. Here’s a great calculator I found that tells you how much you could put away in each type of plan for your given income.
2) Higher catch-up contributions. After age 50, you can put $50K per year into a SEP-IRA. But you can put $54,500 into a Solo 401K.
3) Loans. You can borrow money from a solo 401K but not a SEP-IRA. You shouldn’t borrow from either, but at least the option is there in case of catastrophe.
4) Roth Conversion/Back-door Roth IRAs. SEP-IRAs must be taken into the pro-rata calculation when converting non-deductible IRAs to Roth IRAs. Solo 401Ks are not subject to that rule.
5) Roth Contributions. Inside a Solo 401K, your “employee contributions” (up to $16,500) can be designated as Roth contributions. This not only allows you some tax diversification benefits, but also allows you to save more money in a tax-protected manner, since after-tax money is worth more than pre-tax money.
6) Asset Protection Benefits. Although most states protect IRAs and 401Ks equally from creditors, at least two (MN and SC) give additional protection to 401Ks over IRAs.
That’s a lot of advantages. Yet I have used a SEP-IRA several times and have never opened a Solo 401K. Why is that? I never actually needed any of these advantages. If you’re already maxing out an employee 401K at one job (or make more than $254K), don’t need a loan, don’t want to use Roth options (or convert all your SEP-IRA contributions to a Roth IRA), and are under 50, why not choose the simple and easy option? You can always roll the SEP-IRA over into a solo 401K if you change your mind.
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Good stuff.
But what about cost? Solo 401ks are more expensive, aren’t they?
another option is to create a defined benefit plan. Depending on your age, you can contribute a lot more per year. Im now 41 and can contribute about 70k and can also have an associated 401k/PS with it that i can contribute another 31k towards. The big problems with the defined benefit plan is that yearly funding is mandated (it isnt flexible) and it costs much more to have. Schwab seems to have a good low cost situation for starting one. Whatever you do, however, avoid the 412i and 412e, defined benefit plans. Google 412e white paper to figure out why its a bad idea.
Solo 401K at Vanguard doesn’t cost anything more than a SEP-IRA, which is basically nothing aside from the ERs of the funds.
@ Rex- A defined benefit plan can be held in addition to a 401K. For example, the defined benefit plan in my group allows $31K in addition to the $49K that I can put into the 401K. I wouldn’t hold a DBP instead of a solo 401K or SEP-IRA. There are additional costs and flexibility issues associated with it.
yes that is correct and what i was trying to say in my post that you can have both as well. if you have a defined benefit plan, you typically should be able to contribute more than 31k per year but that then effects the total you can contribute to your 401k piece. In your situation, you have sort of done the opposite of what most do which is max out the DB and then you would only be able to put 31k into your defined contribution or 401k piece. The reason to do it that way is bc you can then ensure you have put away enough to get the defined benefit amount while the 401k piece may be greater or less depending on returns. The negatives of that approach are the decreased flexibility you mentioned. Since you are paying for both, its really up to you which way to handle it especially if you are a 1099 person.
Not sure I follow you exactly. Defined benefit plans come in a lot of flavors. Ours is limited (in fact it’ll probably go down to $15K next year instead of $31 due to top-heavy rule issues) due to the structure of the business and number of participants. Ours is actually invested in a reasonable mix of mutual funds (60/40) and so it is dependent on performance as well. Since you can roll it out into an IRA as soon as you separate from the company, it’s really just some additional 401K space where you don’t get to choose how it is invested.
They do come in a few flavors but your article is targeted towards 1099 folks. In this situation, you can greatly control the investments. As a 1099 person, the issue then becomes are the costs of having such a plan worth it. In my opinion, the best way for a 1099 would be sep until mid 50s when hopefully kids out of college and at that point change to db plan with a 401k. The deductions would be high and greatly increase your tax deferred space. At that point the costs likely aren’t as bug a deal.
If you are employed by a nonprofit hospital system, can you take advantage of any additional tax savings or SEP if you already have a 401K with the employer? Any good books that would help an employed physician save on taxes? Thanks
No, you cannot do a SEP or a solo 401K unless you have a separate moonlighting independent contractor (1099) job.
You could do backdoor Roths and maybe an HSA though.
I don’t know of a tax book specific to an employed physician. You might browse through my bookstore though and see if something there seems to fit. Maybe taxes for dummies. Or perhaps an investing book such as the Bogleheads Guide that would discuss various tax-protected and tax-efficient ways of investing.
I have a question about the terminology of these accounts. I will be setting up one of these accounts this year for my 1099 income. I have been looking through the tax documents and they mention the SEP, SIMPLE IRA, and SIMPLE 401k. I do not see anything about the Solo 401k as being tax deductible. On Vanguard I see the Individual 401k, SEP-IRA, and SIMPLE IRA listed. Is the Solo (Individual) 401k the SIMPLE 401k?
Thank you.
No. The solo 401K is the individual 401K. A SIMPLE is different and not desirable for a sole practitioner without employees.
Thanks for the quick reply. I’m just confused on the tax deductions for the two different accounts. On the IRS pub 560, they list the SEP and SIMPLE accounts as qualified tax deductible accounts for self-employed income, which goes into line 28, but there is no information in the document about the solo 401k. Does the solo 401k also get included in that line? Or am I wrong in thinking that it would be a tax deductible account?
In Pub 560, 401Ks are called qualified plans (section 4.) I’m not sure exactly how it gets entered on the 1040. I think it is deducted out as a business expense because with my regular old 401K, that money isn’t included on my W-2 box 1. So I don’t think you have to take it back out on line 28 like a SEP-IRA.
I think that’s right. I think you deduct it on line 19 of schedule C. Oh never mind. The instructions for Schedule C say put it on line 28 if you’re the only employee.
Ah great. Thanks for the help. I kept reading that document as SIMPLE 401k being what they refer to as a 401k, but I now see that they mean that when they refer to it directly. So both plans are handled in the same way with taxes – tax the amount on the self-employment tax but the adjusted gross income decreases by that amount. I wanted to make sure I didn’t miss out on an additional break on the self-employment taxes if I went with one over the other.