SEP IRA vs. Solo 401(k): Which One is Right for Your Business?

Do you own a small business and are considering starting a retirement plan for your employees and yourself? Are you not sure about which one is right for your business? Both SEP IRAs and solo 401(k)s are retirement accounts that allow you as the business owner to build tax-deferred savings to use for retirement for your employees and yourself. Both accounts are very similar with one huge difference: the business owner can make contributions to a solo 401(k) as both the employer and employee. Keep reading for a detailed review of SEP IRAs and solo 401(k)s, so you can make the best decision for your business, employees, and yourself.

SEP IRA

SEP IRA stands for Simplified Employee Pension Individual Retirement Account, known as a SEP IRA. Small business owners can contribute to this retirement account both for their employees and themselves. It is a tax-deferred retirement account, which means the business owners contributions are tax deductible and the earnings grow tax-free. It operates much the same way as a traditional IRA, which means the money will be taxed when you withdraw the money to use during retirement.

Contribution Limits. One of the huge differences over a traditional IRA is the contribution limits. With a SEP IRA, you can contribute a much larger amount. In 2020, the total contributions can be up to 25% of the employee’s salary with a cap of $57,000. This is much larger than the contribution limits for a traditional IRA, which allows $6,000 ($7,000, if 50 years old or older) to be contributed in 2020.

The IRS requires you to contribute the same amount to every eligible employee including yourself. This means if you contribute, as an employer, 20% of your salary to your own SEP IRA, you must also contribute 20% of your employee’s salary to each eligible employee’s SEP IRA.

Employees cannot contribute to SEP IRAs, only the employer.

Eligible Employee. Under the IRS criteria, the majority of employees are eligible. However, they must be at least 21 years old, earned at least $600 from your business in the past year, and worked for your business for at least three of the past 5 years.

Tax Deduction. Because the SEP IRA is tax-deferred, all the contributions are tax deductible from your business taxes.

Solo 401(k)

A solo 401(k) provides a way for individuals, who are self-employed, to save more for retirement than a traditional or Roth IRA will allow. You only qualify for a solo 401(k), if you and your spouse are the only business employees. If you have other employees, you will not qualify for a solo 401(k). The solo 401(k) functions very similarly to 401(k) offered by companies to their employees. It is a tax-deferred account, which grows tax-free and can be funded with pre-tax dollars. This means you do not pay tax on the money you set aside in the solo 401(k) until you make withdrawals during retirement.

Contribution Limits. For 2020, employees can contribute up to $19,500 to a solo 401(k). If you are 50 years old or older, you can contribute an additional $6,500 (or up to $26,000). The 401(k)s offered by companies have the same contribution limits. As an employer, you also can contribute up to 25% of your salary to your solo 401(k). Total contributions cannot exceed $57,000 for 2020 ($63,500, if you are 50 years old or older).

Tax Deduction. You can deduct from your business taxes any deductions made to your solo 401(k) up to the contribution limits. You also can use pre-tax dollars to fund your contributions you make as an employee.

The Bottom Line

Both SEP IRAs and solo 401(k)s provide a tax-deferred account to save for retirement. They provide small business owners a way to save more for retirement than what traditional or Roth IRAs allow. Business owners can take a tax deduction for the amount they contribute to employees’ retirement accounts. Employees can use pre-tax dollars to make contributions to the solo 401(k) as well. The withdrawals are taxed when the money is used during retirement. If funds are withdrawn early, the money will be taxed and a penalty will be applied, unless an exception applies.

If you are not sure if you should open a SEP IRA or a solo 401(k), the answer is easy if you have employees other than your spouse: a SEP IRA. You do not qualify for a solo 401(k), if you have employees. Also, opening a solo 401(k) requires a lot more paperwork, so you should only open one up if you plan on contributing more than the allowed contribution limits for a traditional or Roth IRA.

To determine the best tax strategy for your business and which retirement account will serve your needs most, contact the tax professionals at Gudorf Tax Group to schedule an appointment.

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