One of the more important decisions a small business owner must make is what type of retirement plan to set up for the business and the owners/employees. For a business that has no non-owner employees, in general, the decision is between a SEP IRA and a Solo 401(k) plan. This article will detail the advantages and disadvantages of both plans and explain why the Solo 401(k) continues to be the most popular retirement plan for the self-employed or small business owner with no-full time employees. Note – this article will not focus on businesses that have non-owner full-time employees. In such cases, the 401(k), specifically a safe harbor 401(k) plan, is the most popular type of retirement plan.
- Solo 401(k)s and SEP IRAs are the two most popular small business retirement plans
- In almost all aspects, the Solo 401(k) is the superior option
- SECURE Act 2.0 has brought in some extra benefits
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 allows the employer to make 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 $66,000 for 2023 or $61,000 for 2022. A SEP IRA does not include a catch-up contribution option for those who have reached age 50.
Further, a SEP IRA is a pure profit-sharing plan that does not include any employee deferrals. This means means you need to have a lot more profits in order to maximize your contributions. However, thanks to SECURE Act 2.0, starting in 2023, SEP IRA contributions can now be made in pretax and Roth. This change should make the plan a bit more popular with business owners seeking to maximize Roth contributions.
What is a Solo 401(k)?
A Solo 401(k) plan is an IRS-approved retirement plan, which is designed for business owners who do not have any employees, other than themselves, their spouse or other owners. It is not a new type of plan and 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 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 plan, one must meet just two eligibility requirements:
- The presence of self-employment activity.
- The absence of full-time employees.
In sum, so long as the individual has a business, with any entity type, and the business has no full-time employees other than the owner(s) or their spouse(s) (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 40(1k). Under the 2023 contribution rules, a plan participant under the age of 50 can make a maximum annual employee deferral contribution in the amount of $22,500 ($20,500 for 2022). That amount can be made in pretax, after-tax, or Roth. On the profit-sharing side, the business can make an additional 25% (20% in the case of a sole proprietorship or single member LLC) contribution based on the amount of the net Schedule C amount or W-2, as applicable, up to the combined maximum, including the employee deferral, of $66,000 ($61,000 for 2022).
For plan participants who are at least age 50, those amounts are $30,000 ($27,000 in 2022) and $73,500 ($67,500 in 2022) respectively. Again, SEP IRA is limited to the profit sharing contribution (up to the maximum) and there is no catch-up contribution once you reach age 50.
Real Life Examples
Below are several examples illustrating how the Solo 401(k) plan and SEP IRA contribution rules work.
Example 1: Rob is 42 years old and has a sole proprietorship. He earns $60,000 of net Schedule C income in 2023. If Rob wished to maximize his contributions to his Solo 401(k) plan, he could make $22,500 for the employee deferral, plus 20% of his income, or $12,000, giving him a total $34,500 contribution. Whereas, if Rob had set up a SEP IRA, he would be limited to the $12,000 profit sharing contribution for 2023.
Example 2: Same facts as Example 1, but let’s assume Rob is 57 years old and earned $60,000 of net Schedule C income in 2023. If he wished to maximize his contributions to his Solo 401(k) plan, he could make a $30,000 contribution is the employee, plus the $12,000 profit sharing contribution, giving him a total $42,000 contribution. Again, if Rob had a SEP IRA, he would be limited to the same $12,000 as above.
Example 3: Sean is 47 years old and has a business set up as an S corporation. Assume Sean earns $100,000 of W-2 income for 2023. If he wished to maximize his contributions to his Solo 401(k) plan, he could make $22,500 in employee deferrals, plus a 25% profit sharing contribution of $25,000 giving him a total $47,500. Whereas, if Steve had set up a SEP IRA, he would be limited to the 20% profit sharing contribution, or $20,000.
Example 4: Same facts as Example 3, but let’s assume Sean earned $500,000 of W-2 income in 2023. If Sean wished to maximize his contributions to his Solo 401(k) plan, he could make a $30,000 employee deferral, plus 20% of $500,000 or $100,000. However, since his maximum contribution would exceed the $66,000 maximum contribution threshold, Sean would be limited to $66,000 as his contribution amount for 2023. If Sean had a SEP IRA, he could contribute up to 20% of $500,000 or $100,000. However, like the Solo 401(k), Sean’s SEP IRA contribution maximum would be limited to $66,000.
In sum, this is one of the few scenarios where a business owner could select a SEP IRA over a Solo 401(k) plan. The other would be annual administration (see below).
More Reasons to Go Solo
There are many more reasons why to choose the Solo 401(k) vs. a SEP IRA. Here are a few more:
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 loan must be paid back at least quarterly over a five year period. The lowest interest rate allowed is the Prime interest rate, which, as of January 1, 2023, is 7.50%. 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
One of the major benefits prior to 2023, was the ability to make Roth contributions to a Solo 401(k). Note that only the employee deferral can be made in Roth; profit sharing contributions must be made pretax.
Starting in 2023, as a result of Section 601 of SECURE Act 2.0, SEP IRA contributions can now be made in pretax or Roth. As mentioned above, if you really want to take advantage of tax-free distributions with a Roth, a SEP may now be an option for you.
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 and cryptos. The only difference between the plans from an investment standpoint is that a Solo 401(k) plan can buy life insurance and is exempt from UBTI for nonrecourse leverage used for a real estate acquisition project (continue reading for more info).
Non-recourse 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 (UDFI) rules and the Unrelated Business Taxable Income (UBTI) tax. This exception, found in IRC Section 514(c)(9) is only applicable to 401(k) qualified retirement plans, not IRAs.
If one would make a real estate investment with a SEP IRA and needed to use leverage for the purchase, you would trigger the UBTI and be subject to tax on the income generated from the property. Therefore, if you are self-employed and looking to invest in real estate, going Solo is the best option.
The annual administration of the SEP IRA is one of the areas where the SEP IRA is equal or better than a Solo 401(k). In the case of a SEP IRA, the IRA custodian, such as IRA Financial, that holds the plan 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 that form, if applicable.
Overall, just like last year, in 2023, the Solo 401(k) plan is a far superior retirement plan for the self-employed or small business over than a SEP IRA. SECURE Act 2.0 provided the SEP IRA with additional benefits, such as a Roth option, however, the fact is the SEP is still only a profit-sharing plan, there’s no catch-up, does not have a loan feature and could be subject to UBTI tax for real estate investments.
Obviously, not every small business can qualify for a Solo 401(k). For those who can’t, the SEP IRA is a viable option. As your business grows, you might need to move on to a safe harbor 401(k) plan. Either way, make sure you do your diligence before deciding on a plan that’s right for you and your business.