SEP IRA vs Solo 401(k) - How do they differ?
Updated: Apr 23, 2021
When it comes to retirement plans for people who (1) earn income from self-employment, and (2) don’t have any full-time W-2 employees working more than 1,000 hours per year, most think that a SEP IRA is their best and/or only option. This is not necessarily the case.
While it does allow for a high contribution limit, ($57,000 for 2020 and $58,000 for 2021) as a way to defer income tax until retirement, and the ability to be invested in traditional investments, that’s about all it offers.
The Self-Directed Solo 401(k) starts with those features, but then goes above and beyond to provide several other beneficial provisions.
1: Self-Directed Solo 401(k)s allow for higher contribution amounts, within annual limits.
When a business owner or 1099 independent contractor contributes to a SEP IRA, they do so via what’s called a Profit-Sharing contribution. The amount allowed is based on how they’re taxed.
They can contribute up to 20 percent of their net income from self-employment if they are set up as an LLC, Partnership, or Sole Proprietor. They can contribute up to 25 percent of their salary from self-employment if they are set up as an S-Corporation or C-Corporation. The amount contributed, however, cannot exceed the annual limit of $57,000 for 2020.
Contribution example for a SEP IRA: Olivia made $100,000 in net income in 2020 (after deductions and less ½ self-employment tax) from her one-person Etsy business set up as an LLC. The SEP IRA will allow her to contribute up to $20,000 ($100,000 * 20%) for 2020 bringing her taxable income to $80,000.
The Self-Directed Solo 401(k), on the other hand, allows for an Elective Salary Deferral contribution to be made in addition to the Profit-Sharing contribution. The amount that can be contributed as salary deferral is up to 100 percent of net income from self-employment not to exceed the 2020 and 2021 annual limit of $19,500 for people who are less than 50 years old.
People who are 50 years old and over can make a salary deferral catch-up contribution of an additional $6,500, bringing their 2020 and 2021 annual limit to $26,000. The profit-sharing contribution calculation is the same for the Self-Directed Solo 401(k) as it is for the SEP IRA.
The combined limit for both contribution types cannot exceed $57,000 for those under 50 years of age, or $63,500 for those 50 years old and older. (In 2021 the combined limit can not exceed $58,000 or $64,500 respectively.)
Contribution example for a Self-Directed Solo 401(k): Olivia can contribute $20,000 as profit-sharing, as illustrated in the SEP IRA example above, but now she can also add $19,500 as salary deferral, bringing her combined contribution limit to $39,500 and her taxable income down to $60,500. If Olivia were 50 years old or older, she could also include the catch-up of $6,500 for a total contribution of $46,000, reducing her taxable income to $54,000.
Since both plans have the same annual limit of $57,000, it is important to understand the break-even income level when the 20 or 25 percent profit sharing contribution will equal $57,000 and the salary-deferral addition no longer helps to increase the contributable amount.
For 2020, the break-even net income for Solo Proprietors, Partnerships and LLCs is $285,000, and for S-Corporations and C-Corporations the break-even salary is $228,000. However, if the person is 50 years old or older, the catch-up contribution portion of the salary-deferral will increase the limit to $63,500. So, for anyone in this age group, the Self-Directed Solo 401(k) would be better from a contribution limit standpoint.
Tip! SEP IRAs and Solo 401(k)s can be established and contributed to for the 2020 tax year up until the tax filing deadline (plus extension).
2: Self-Directed Solo 401(k)s allow for loans to be taken out, (if the plan is designed to include a loan provision.)
No IRA retirement plan allows for loans to be taken against the account. Self-Directed Solo 401(k)s do allow for loans up to $50,000 or 50 percent of the balance in the account, whichever is less, tax and penalty free, to be used for any reason without restriction. They must be repaid, generally within five years, but if it’s used for the purchase of a primary residence, they have 15 years to pay it back.
Payments must be made no less than quarterly; any amount not repaid from a loan, (after grace periods are exhausted,) will be considered a distribution, and any applicable taxes and penalties will be due by the account holder.
Interest is owed on the loan, typically prime + 1 percent, but the interest goes back into the account and added to the retirement funds, as opposed to it going to a financial institution, which would be the case with a typical bank loan. (Here is more information about the loan that can't be denied.)
3: Self-Directed Solo 401(k)s allow for self-directed asset class diversification.
SEP IRAs generally require a custodian, such as a financial institution, to hold and direct the funds to be invested in the products that they sell, such as stocks, mutual funds, etc. This prevents the account holder form being the trustee and limits their ability to diversify by asset class. It also increases the cost to manage the account.
Self-Directed Solo 401(k)s allow the account holder to be the trustee and do not require a custodian, which helps to reduce the cost involved. They are free to self-direct the funds to be invested in almost any asset class, including, but not limited to: residential and commercial real estate; tax liens, deeds, and foreclosures; the stock market, funds, bonds, futures and options; most business types; private and hard money loans; land; oil and gas mineral rights; select precious metals and some coins. Prohibited Transaction and Disqualified Person rules apply and must be followed when engaging in any investment transaction.
There are very few assets that the account cannot invest in/own. They include S-Corporations because the Self-Directed Solo 401(k) cannot be a shareholder of a business. It also cannot invest in art, or collectibles, such as stamps and baseball cards. Some would argue that life insurance contracts can be owned by Self-Directed Solo 401(k)s, but many more think that it doesn’t make sense, so it’s included here.
4: Self-Directed Solo 401(k)s allow high contribution amounts for tax-free money in retirement, (if the plan is designed for it.)
SEP IRAs can only be contributed to via pretax profit-sharing contributions. This is great for tax-deferral purposes, but if tax-free money in retirement is the goal, the Self-Directed Solo 401(k) is the better option because it allows for Roth and Voluntary After-Tax contributions.
First, the salary deferral portion (up to $19,500) can be contributed after-tax to a designated Roth account. If the account holder isn’t particularly concerned about tax savings through deferral today and wants to increase his or her tax-free money in retirement, here’s a strategy for maximization: The account holder can make a Roth salary deferral contribution and the pre-tax profit-sharing contribution.
They can then convert the profit-sharing contribution to the Roth account and pay the tax on it. The account holder is then able to invest all of the funds through their Roth account so that the basis, gain, and income generated by the investment(s) will all be tax-free upon withdrawal.
Second, 100 percent of net income from self-employment, (up to the annual limit,) can be contributed via a voluntary after-tax contribution. Since the income and gain on after-tax contributions is taxable upon withdrawal, the account holder will want to convert the money to the Roth account right away. This method of contributing voluntary after-tax funds and then converting them to a Roth account is frequently referred to as a Mega Backdoor Roth.
Contributing after-tax dollars is also a way to reach, and maximize, the contribution limit amount of $57,000, or $63,500, since it can be made in addition to the salary deferral and profit-sharing contributions. For example, look at Olivia’s Self-Directed Solo 401(k) scenario again, and assume that she is less than 50 years old. Olivia was only able to contribute $39,500 because of her income level. If she wants to max out the full contribution amount, she could add an additional $17,500 of after-tax dollars to reach the $57,000 limit.
Cherry on top.
Not all account holders are able to shave off a large portion of their net income or salary so that they can maximize their retirement contribution amount, but the Self-Directed Solo 401(k) gives them the ability, and the option, to contribute more than just the profit-sharing limit that the SEP IRA allows for, if they want, and depending on their entire financial situation. Having a high contribution limit can make a big difference to a business owner’s tax liability and possibly bring him or her down to a lower tax bracket.
The increased provisions, flexibility, and self-direction that the Self-Directed Solo 401(k) plan affords is like the hot fudge, whipped cream, sprinkles, and cherry on top of the SEP IRA scoop of plain vanilla.
For any qualifying person who wants to maximize his or her contribution amounts and options, and tax efficiencies today and/or in retirement while having direct control over a diversified and custom-made investment portfolio, this option checks off more boxes than the SEP IRA.
Source - Here is the link to this article that I originally wrote for The Daily CPA: 4 Key Advantages to Having a Self-Directed Solo 401(k) Instead of a SEP IRA - (thedailycpa.com)