Self-employed individuals have a leg up on W-2 employees in saving for retirement and cutting their tax bills thanks to more generous tax-deductible retirement plan contribution limits on SEP-IRAs, Solo 401(k)s (also called “Individual 401(k)s”) and defined benefit plans.
This piece will address the one circumstance, in our view, that individuals with income from self-employment should set up a SEP-IRA. For those who are already contributing the maximum to a SEP-IRA or Solo 401(k), a defined benefit plan will likely permit even larger tax-deductible contributions. To learn about defined benefit plans, click here.
Did you have self-employment income in 2018? Do you want to shelter some of that income from taxes and invest in your retirement, but you missed the December 31, 2018 Solo 401(k) deadline? You still have a decent option available:
- Set up a SEP-IRA now, before your tax filing deadline
- Make your contribution to that account for 2018
- Then, for 2019, make sure you set up a Solo 401(k) before the end of the year.
Because the SEP-IRA has a later establishment deadline (your tax filing deadline) than a Solo 401(k) (December 31 of the tax year of the contribution), this is the only time a SEP-IRA beats out a Solo 401(k). In all other ways the Solo 401(k) is a superior plan, in our opinion.
First, what is a Solo 401(k) and why is it better than a SEP-IRA?
- Can be established and funded until your tax-filing deadline, which is April 15th for most people
- Allows you to contribute 25% of profits, with a 2019 contribution limit of $56,000
- Does not permit loans
- Does not allow “catch-up” contributions for those over 50
A Solo (or Individual) 401(k):
- Must be established by December 31 of the year you want to contribute (funding can come later)
- Allows you to contribute 25% of profits, with a 2019 contribution limit of $56,000. This includes a $19,000 “salary deferral” contribution
- Includes an additional $6,000 “catch-up” contribution if you are over 50 for a total of $62,000
- Loans may be permitted from Solo 401(k)s
Because you can usually make a significantly larger contribution to a Solo 401(k) than to a SEP-IRA at a given income level, the Solo 401(k) is usually a superior choice for self-employed individuals with no employees. Higher contributions mean more tax savings and faster growth of your retirement account.
The relative advantage of a Solo 401(k) over a SEP-IRA is most stark for individuals at lower income levels. Let’s look at an example under both plans:
- Someone earning $50,000 of income from self-employment could contribute around $10,000 to a SEP. (SEP rules state you can contribute 25% of compensation, but that usually boils down to around 20% once you go through the calculation.)
- This same person, however, would be able to contribute $31,500 to a Solo 401(k)– $12,500 plus $19,000 of salary deferral. Thus, at lower levels of self-employment income, the Individual 401(k) offers much better tax-savings potential.
If you missed the December 31 Solo 401(k) deadline, what should you do?
- Establish a SEP-IRA before your 2018 tax filing deadline and make the maximum contribution for 2018.
- Then, for 2019, establish a Solo 401(k) and roll the assets from the SEP into the new 401(k).
- Shut down the SEP-IRA and contribute only to the Solo 401(k) going forward.
Please contact us if you would like us to offer our views on how, for your particular circumstances, you can best cut your tax bill while saving for retirement.
If you earn over $100,000 in self-employment income, read more about what we consider the most powerful retirement plan, called a defined benefit plan.