posted by: Radnor Financial Advisors
Many individuals find themselves self-employed after spending years as a W-2 employee. Perhaps the self-employment is in the form of consulting or serving on a corporate board. Often, such roles can result in significant taxable income. In such situations, tax planning can be very beneficial and result in substantial tax savings.
A primary strategy for reducing taxable income for self-employed individuals is the use of one of the available retirement plans to defer income from self-employment. There are a number of plans that self-employed individuals are eligible to utilize, but the two most beneficial plans are the Simplified Employee Pension (SEP IRA) and the Solo 401(k). While the benefits can be similar, there are a few key differences that make planning prudent.
Simplified Employee Pension (SEP IRA)
Contribution Limit – $56,000 (2019)
The SEP IRA has simple in its name, and it’s meant to be just that – simple. The plan is easy to set up and make contributions. The maximum contribution is calculated when that year’s tax return is prepared, and the contribution needs to be made prior to filing the return. Given this, a SEP IRA account can be opened and funded after year end, and the process to do so is fairly simple. The maximum contribution is calculated below (subject to the $56,000 limit).
For someone making $100,000 of Self-Employment Income, the calculation may look similar to this:
A significant feature of the SEP IRA is the ability to contribute to both the SEP IRA and an employer-sponsored 401(k) plan. So if you consult while still working for a company and contributing to that company’s 401(k) plan, you can contribute up to $56k in the SEP IRA PLUS the $19k 401(k) contribution limit. That adds up to $75k (PLUS a $6k 401(k) catch-up contribution for those over 50).
Contribution Limit – $56,000/$62,000 for those over 50 (2019)
a Solo 401(k) replaces a traditional 401(k). There is an employee contribution
and an employer contribution. The employee (EE) portion is tied to the
contribution limits for a traditional 401(k); for 2019, the contribution limit
is $19,000 plus a catch-up contribution limit of $6,000 for those over 50. The
employer’s (ER) contribution is limited to the lesser of 20% of net
self-employment income or $37,000 for 2019. The formula for determining the
maximum Solo 401(k) is a follows:
For a 45 year-old earning $100,000 of self-employment income, the calculation may look like this:
There is a little more administration involved with a Solo 401(k). The employee contribution must be made during the calendar year. Once the net income has been calculated and finalized during the preparation of the tax return, the employer contribution can be calculated and made (typically in March/April of the following year). Unlike the SEP which requires only one contribution, the Solo 401(k) requires two contributions spread over two years. Since the employee contribution needs to be made during the calendar year, a Solo 401(k) account needs to be opened prior to the end of the year.
The other disadvantage of a Solo 401(k) is that contributions to an employer-sponsored 401(k) plan reduce the ability to contribute to a Solo 401(k). For example, if an individual works for ABC Corp and maxes out his or her contributions to the ABC Corp’s 401(k) plan, that individual is unable to make an employee contribution to a Solo 401(k) plan.
If we compare the two plans directly at various income levels, the results are as follows:
For those under 50 and earning less than $300,000, the Solo 401(k) allows the individual contribute significantly more than the SEP plan. Once the individual earns around $300,000, the contribution limits for both plans are capped at $56,000. However, for those above the age of 50, the Solo 401(k) continues to be more beneficial as the individual can make an additional $6,000 catch-up contribution whereas such additional contribution is not available for the SEP IRA.
For many self-employed individuals, SEP IRAs and Solo 401(k)s can offer significant tax benefits. Each plan type has pros and cons, and it is beneficial to consider both plans when opening a retirement account.
Author: Mike Valenti, Senior Tax Associate