When it comes to looking for the best retirement plan for the self-employed or small business owner with no full-time employees other than himself/herself or a spouse, the options generally include the SEP IRA and the solo 401(k) Plan. Generally, unless one has earned sufficient income to max out on a SEP IRA contribution (typically above $260,000 for 2014), the solo 401(k) plan offers far more advantages than a SEP IRA.
A Solo 401(k) plan” is an IRS approved retirement plan, which is suited for business owners who do not have any employees, other than themselves and perhaps their spouse. The “one-participant 401(k) plan” or individual 401(k) Plan is not a new type of plan. It is a traditional 401k plan covering only one employee. Like a SEP IRA, a Solo 401k Plan offers the Plan participant the ability to contribute up to $57,500 each year. Before the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) became effective in 2002, there was no compelling reason for an owner-only business to establish a Solo 401(k) Plan because the business owner could generally receive the same benefits by adopting a profit sharing plan or a SEP IRA. After 2002, EGTRRA paved the way for an owner only business to put more money aside for retirement and to operate a more cost-effective retirement plan than a SEP IRA or 401(k) Plan.
There are a number of options that are specific to Solo 401k plans that make the Solo 401k plan a far more attractive retirement option for a self-employed individual than a SEP IRA.
1.Reach your Maximum Contribution Amount Quicker: A Solo 401(k) Plan includes both an employee and profit sharing contribution option, whereas, a SEP IRA is purely a profit sharing plan.
Under the 2014 new Solo 401(k) contribution rules, a plan participant under the age of 50 can make a maximum employee deferral contribution in the amount of $17,500. That amount can be made in pre-tax or after-tax (Roth). On the profit sharing side, the business can make a 25% (20% in the case of a sole proprietorship or single member LLC) profit sharing contribution up to a combined maximum, including the employee deferral, of $52,000, an increase of $1,000 from 2013.
For plan participants over the age of 50, an individual can make a maximum employee deferral contribution in the amount of $23,000. That amount can be made in pre-tax or after-tax (Roth). On the profit sharing side, the business can make a 25% (20% in the case of a sole proprietorship or single member LLC) profit sharing contribution up to a combined maximum, including the employee deferral, of $57,500, an increase of $1,000 from 2013.
Whereas, a SEP IRA would only allows for a profit sharing contribution. Hence, a participant in a SEP IRA would be limited to 25% (20% in the case of a sole proprietorship or single member LLC) profit sharing contribution up to a combined maximum of $52,000 for 2013. No employee deferral exists for a SEP IRA.
For example, Joe, who is 60 years old owns 100% of an S Corporation with no full time employees. Joe earned $100,000 in self-employment W-2 wages for 2013. If Joe had a Solo 401(k) Plan established for 2014, Joe would be able to defer approximately $48,000 for 2013 (a $23,000 employee deferral, which could be pre-tax or Roth, and 25% of his compensation giving him $48,000 for the year). Whereas, if Joe established a SEP IRA, Joe would only be able to defer approximately $25,000 (25% if his compensation) for 2014.
2.No catch-up Contributions: With a Solo 401K Plan you can make a contribution of up to $52,000 to the plan each tax year ($57,500 if the participant is over the age of 50). However, with a SEP IRA, the maximum amount that can be deferred is $52,000 since a SEP IRA does not offer any catch-up contributions.
3. No Roth Feature: A Solo 401k plan can be made in pre-tax or Roth (after-tax) format. Whereas, in the case of a SEP IRA, contributions can only be made in pre-tax format. In addition, a contribution of $17,500 ($23,00, if the plan participant is over the age of 50) can be made to a Solo 401(k) Roth account.
4. Tax-Free Loan Option: With a Solo 401K Plan you can borrow up to $50,000 or 50% of your account value what ever is less. The loan can be used for any purpose. With a SEP IRA, the IRA holder is not permitted to borrow even $1 dollar from the IRA without triggering a prohibited transaction.
5. Use Nonrecourse Leverage and Pay No Tax: With a Solo 401(k) Plan, you can make a real estate investment using nonrecourse funds without triggering the Unrelated Debt Financed Income Rules and the Unrelated Business Taxable Income (UBTI or UBIT) tax (IRC 514). However, the nonrecourse leverage exception found in IRC 514 is only applicable to 401(k) qualified retirement plans and does not apply to IRAs. In other words, using a Self-Directed SEP IRA to make a real estate investment (Self Directed Real Estate IRA) involving nonrecourse financing would trigger the UBTI tax.
6. Open the Account at Any Local Bank: With a Solo 401k Plan, the 401k bank account can be opened at any local bank or trust company. However, in the case of a SEP or a Self Directed IRA, a special IRA custodian is required to hold the IRA funds.
7. No Need for the Cost of an LLC: With a Solo 401(k) Plan, the plan itself can make real estate and other investments without the need for an LLC, which depending on the state of formation could prove costly. Since a 401(k) plan is a trust, the trustee on behalf of the trust can take title to a real estate asset without the need for an LLC.
8. Better Creditor Protection. In general, a Solo 401(k) Plan offers greater creditor protection than a SEP IRA. The 2005 Bankruptcy Act generally protects all 401(k) Plan assets from creditor attack in a bankruptcy proceeding. In addition, most states offer greater creditor protection to a Solo 401(k) qualified retirement plan than a SEP IRA outside of bankruptcy.
The Solo 401k plan is unique and so popular because it is designed explicitly for small, owner only business. The many features of the Solo 401k plan discussed above is why the Solo 401k Plan or Individual 401k Plan it so appealing and popular among self employed business owners.
To learn more about the benefits of a Solo 401(k) Plan vs. a SEP IRA, please contact a tax professional at 800-472-0646.