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Deciding Between A SEP IRA And A Solo 401k For Your Business

The self-employed and those who run private practices must manage a whole myriad of concerns, which regular employees do not. But there are ways that the self-employed benefit from the status, and there’s no better example of that than with retirement plan options.

It’s a tool, however, that those that work for themselves are often slow to embrace.

Figures remain scant on just how much those who are self-employed save or take advantage of these plans. But past surveys have indicated that fewer than two-in-ten of the self-employed who work in a solo business have a retirement account that they fund. It’s woefully low when compared to rates of employee participation in employer plans, which nears 75%.

There are reasons for this slow adoption, of course. When building a business, often an owner will sacrifice savings today for revenues tomorrow. But, by doing so, they’re also giving away opportunities to cut their taxes and build a secondary income stream in the form of retirement or financial independence savings.

If a business owner begins to weigh retirement plans, there are two specific tools that they tend to consider: the solo 401(k) or the SEP individual retirement account (SEP IRA or SEP).

It’s important to understand the benefits and downsides to each, which can help you decide which plan to pursue.

The Independence of a Solo 401k

All else being equal, the Solo 401k is one of the most dynamic long-term investing tools that anyone can select. Why? The amount of control you have over what you can add to the account.

Most employer-run retirement accounts max the amount that an employee can add at $22,500 for 2023 – $30,000 if you’re over 50. In these accounts, an employer can add additional funds, up to $66,000 in total between employee and employer contributions.

But you’re relying on an employer to make those additional contributions – most employees will not receive a proactive maximum contribution from employers.

In a Solo 401k, however, you’re both the employer and employee. This allows you to add additional funds to your 401k at your leisure. It gives you the opportunity to save based on your revenues, up to $66,000. While only the employer contributions receive immediate tax deferral, it can provide a significant boost to your financial independence goals.

The only limit to these contributions is they cannot exceed your revenue.

This ability to save is limited, though. To operate a Solo 401k, you must have zero employees. It can force a business owner’s hand to select another plan if they must grow beyond a solo business.

The SEP IRA Restrictions

For the SEP IRA, a private practice owner or entrepreneur will need to understand rules that govern the plans. This will limit the amount that you can set aside for yourself, and impact how you pay employees.

When you own a SEP, there are rules to how much you can put towards retirement or long-term investing. You cannot shift more than 25% of your salary to the plan. If you’re a solo practitioner, then that means you cannot move more than 25% of revenues into the IRA. In actuality, the amount you can shift is calculated after you take away deductions for self-employment tax. This results in an effective rate of 20% of income.

If you make $100,000 as a solo business owner, then you’re capped at shifting about $20,000 to the plan. If you make $200,000, then you’re capped at approximately $40,000.

The rules grow even more complicated if you add employees though. As you grow the business, SEP IRAs force business owners to give employees that qualify for the plan the same amount – as a percentage of income – as everyone else.

That means, if you give yourself a 25% contribution, then you must also give your qualifying employees the same percentage. And, with SEP IRAs, employees do not contribute to the plan. Instead, the employer provides the entire contribution.

Employees are immediately vested in the plan, and employers can deduct the contributions on taxes.

It’s ideal for small business owners that want to incentivize employees, but it also requires planning to ensure you’re not overpaying your employees in order to save enough for your own retirement.

Evaluate Your Own Needs

As the owner of the business, you need to evaluate your own needs. If you work for yourself, and you do not have any employees, it’s difficult to find reasons that you wouldn’t opt for the Solo 401k.

One reason you might prefer the SEP? If you work for yourself as a side-gig. With this design, you can contribute fully to an employer 401k, while also providing additional funds to a SEP in the form of employer contributions. You just cannot surpass $66,000 in contributions between the two accounts.

But if you work for yourself, and plan to eventually have employees that you’ll want to incentivize with a retirement plan, then you need to weigh the cost of a SEP IRA or other plan.

It comes down to what revenues do you expect, how do you want to grow, how consistent are your revenue streams and what options might better fit your needs.

Ignoring retirement planning outright, though, for desires of revenues not only hurts returns today in the form of tax savings, but also it cuts into the ability to fund your future needs.

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