For real estate investors, a retirement plan can not only provide a valuable way to reduce taxes and save for retirement, but it can also serve as a great tool to invest in real estate.
The SEP IRA and Solo 401(k) plan are the two most popular retirement plans for self-employed real estate business owners.
Before we get into the differences between the SEP IRA and the Solo 401(k) plan, we want to describe the eligibility requirements for establishing a SEP IRA or Solo 401(k) plan.
- The Solo 401(k) plan and SEP IRA are the two most popular retirement plan options for the self-employed and small business owner
- If you meet the eligibility requirements, the Solo 401(k) is the better option
- Real estate investors have the ability to use leverage without tax when using a 401(k)
Eligibility Requirements for a Solo 401(k) or SEP IRA
Any business can establish a SEP IRA. The key is that the individual or entity establishing the plan must have a business and not just a passive activity or hobby. For example, the individual would need to file a Schedule C on Form 1040 as a sole proprietor or single member LLC or a business tax return. In addition, only earned income from the business that adopted the plan is eligible to be contributed to a SEP IRA.
A Solo 401(k) plan is well suited for businesses that either do not employ any employees or employee certain employees that may be excluded from coverage. To be eligible to establish a the Solo 401(k) plan, an investor must meet just two eligibility requirements:
- The presence of self-employment activity.
- The absence of full-time employees.
The business owner and their spouse are technically considered “owner-employees” rather than “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
Just like the SEP IRA, only a business can establish a Solo 401(k) plan. From an eligibility standpoint, the difference between a SEP IRA and a Solo 401(k) is that any business can set-up a SEP IRA whereas only a business with no non-owner employees, excluding a spouse of an owner, can establish a Solo 401(k) plan.
Related: Beginners Guide to Invest in Real Estate with Retirement Funds
A Simplified Employee Pension IRA (SEP IRA) has traditionally been the most popular retirement plan for the self-employed and small business owner. It 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.
A Solo 401(k) plan is a retirement plan which is specifically suited for business owners who do not have any non-owner employees, excluding a spouse. The primary benefit of establishing a Solo 401(k) plan is the high maximum annual contributions of $61,000 or $67,500 if at least age 50. In addition, the plan has a loan option, as well as a special tax benefit for real estate investments involving leverage.
Why Every Real Estate Business Owner Should Set-up a Solo 401(k)
Any real estate business owner that files a Schedule C or files a corporate or partnership tax return with no full-time employees should turn to the Solo 401(k) plan versus the SEP IRA.
Note – if the investor reports real estate income, such as rental income, using a Schedule E on Form 1040, the real estate activity will likely not be eligible for a Solo 401(k) because it is being treated as passive versus business (Schedule C).
Reduce Taxes & Maximize Savings
The Solo 401(k) can help real estate business owners generate tax deductions as well as sock away a significant amount of money each year.
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. That amount can be made in pretax, 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.
Tracy is 45 years old and has a sole proprietorship real estate business. Tracy earned $60,000 of net Schedule C income from her real estate business in 2022. If Tracy wished to maximize her contributions to her Solo 401(k) plan she could make $20,500 employee deferrals, in pretax or Roth, plus 20% of $60,000 or $12,000 giving her a total $32,500 of Solo 401(k) contributions in 2022. If she had set-up a SEP IRA, she would be limited to 20% of $60,000 or $12,000.
As we mentioned earlier, the SEP IRA is a pure employer profit sharing plan and contains no employee deferral options. As you may know, the employee deferral can be made on a dollar-for-dollar basis. This allows one to reach the limit much faster with a Solo 401(k). Since the SEP only has the profit sharing contribution, the business must also generate much more income to reach the annual limit.
Further, there is no catch-up contribution once you reach the age of 50. This limits the amount you can save in a SEP IRA vs. that of the Solo 401(k) plan.
As shown in the above example, a real estate investor seeking to maximize annual tax deductions and build his or her retirement nest egg would be better served with establishing a Solo 401(k) vs. a SEP IRA.
Solo 401(k) Benefits
Borrow from the Plan Tax Free
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, including finding a real estate project or to help build your real estate business.
The 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. Unfortunately, the SEP IRA does not offer any loan feature. For many small businesses, the 401(k) loan feature is very attractive and can come in quite handy when there is a cash flow crunch.
The Solo 401(k) plan allows savers to choose to make pretax or Roth contributions. After-tax funds cannot be used to fund a SEP because there is no employee deferral with the plan.
The beauty of the Roth is that all qualified distributions are tax free. This included both the money you put into the plan, and any gains or income generated by your investments. It may be the biggest advantage for many retirement savers.
Self-Directed Investment Choices
Both the SEP IRA and the Solo 401(k) plan allow one to make traditional investments, such as stocks. However, alternative asset investments, such as real estate and cryptocurrencies can also be made. Keep in mind, not all solo 401(k) plans allow for alternative asset investments. If you want to invest in nontraditional assets, it is important to work with a company, such as IRA Financial, that has IRS-approved retirement plans for real estate and other alternative asset investments.
Read More: Self-Directed Investment Options
If you want to invest in real estate, the ability to use a nonrecourse loan with a Solo 401(k) plan without tax is one of the biggest advantages the plan has over the SEP IRA. All good real estate investors understand the benefit of using leverage to buy real estate.
Under IRC 514, a 401(k) plan, but not an IRA, is exempt from the UBTI tax. In the case of a real estate investment, the UBTI would be triggered when an IRA uses leverage to make a purchase. Up to a 37% tax would be imposed on the income generated based off the percentage of the financed portion of the real estate property.
With a Solo 401(k), you do not need to worry about UBTI. For that reason alone, any self-employed real estate investor should always opt for the Solo 401(k) vs. the SEP IRA!
The ability to maximize annual tax benefits by making high annual plan contributions, utilize the loan option for any purpose without tax or penalty, and the ability to use leverage to acquire real estate without any tax, makes the Solo 401(k) plan the best retirement plan for the self-employed real estate investor.