By: David I Gensler, MSPA, MAAA, EA
Fortune Magazine recently ran an article touting the benefits of a Solo 401(k) over a SEP-IRA for sole proprietors or single member LLCs with no employees. And for those of you who are sole proprietors or single member LLCs who are looking to maximize your contribution (and thus your tax deduction), the Solo 401(k) is probably the way to go. The article does an excellent job of detailing the distinctions between the two types of retirement plans. I have some thoughts of my own to add. But first, let’s analyze each type of plan.
The Solo 401(k) Plan
The first thing that you have to do is adopt a Solo 401(k) plan document. The plan document must be signed and dated before the end of the year for which you intend to take the deduction. Most financial advisors are affiliated with an investment firm that will allow you to adopt their own prototype document, saving time and fees. It is important for you to confirm that the Solo 401(k) also has a separate feature that will allow for profit-sharing contributions (most do). It is these two features working together (the 401(k) feature and the profit-sharing feature) that allows you to maximize the contributions to the retirement plan.
In 2018, the maximum salary deferral allowed into a 401(k) is $18,500. If you are older than age 50, you get to deduct an additional $6,000 as a 401(k) catch up. The superiority of the Solo 401(k) plan comes from the fact that if you are older than age 50, after subtracting out half of your self-employment taxes (don’t worry, an example will follow) you can then ignore the entire $24,500 when calculating the profit-sharing component of the contribution. That additional profit-sharing contribution will generally equal 20% of your earned income after subtracting out half of your self-employment tax, but before you subtract your 401(k) deferral. This maximizes your contribution to the Solo 401(k) plan because 20% of a higher earned income will simply generate a higher profit-sharing contribution.
If you are a non-corporate entity, all of the contributions (the salary deferrals and the profit- sharing contribution) can be made after the end of the year, as long as they are deposited prior to the filing of the plan sponsor’s income tax return, inclusive of extensions.
The SEP-IRA also requires that you adopt what is usually a one page adoption agreement. If your financial advisor’s investment firm does not have their own Sep-IRA document, you can go onto the IRS’ website (www.irs.gov.org) and download their SEP-IRA document. Note that one thing unique (and sometimes a game saver) is that you can adopt the SEP-IRA after the year has ended and still be able to deduct the contribution retroactive to the prior year. So you are still able to maintain the integrity of the deduction for the prior year. That is one feature that contrasts favorably with the Solo 401(k) where the document must be signed and dated before the end of the year.
For a SEP-IRA, the maximum that you are able to contribute and deduct for non-corporate entities is 20% of your net earned income, after subtracting out half of the self-employment tax. The timing of the contribution is no different than the Solo 401(k). It can be made after the end of the year, but prior to the filing of the plan sponsor’s tax return, inclusive of extensions.
Let’s compare a Solo 401(k) to a SEP-IRA for a sole proprietor who earns $. Let’s assume that the owner is older than age 50.
|The Solo 401(k)|
|1) Earned Income||$50,000.00|
|2) ½ of Self-Employment Tax||$3,532.00|
|3) Net Earnings From Self Employment (1) – (2)||$46,468.00|
|4) Solo 401(k) Salary Deferral||$24,500.00|
|5) Profit-Sharing Contribution (3) X 20%||$9,294.00|
|6) Total Deductible Contribution (4) + (5)||$33,794.00|
|7) Net Taxable Earned Income (3) – (6)||$12,674.00|
|1) Earned Income||$50,000.00|
|2) 1/2 of Self-Employment Tax||$3,532.00|
|3) Net Earnings From Self-Employment (1)-(2)||$46,468.00|
|4) Profit-Sharing Contribution (3) x 20%||$9,494.00|
|5) Net Taxable Earned Income (3)-(4)||$37,174.00|
Things To Note
- If you choose to make both a 401(k) salary deferral and a profit-sharing contribution to the Solo 401(k) your life will be easier if you do it in two separate checks. Label one as the 401(k) deferral and the other as the profit-sharing contribution.
- If you own more than 80% of another business (any business) that has employees, they must be covered by either the Solo 401(k) or the SEP-IRA. The fact that the businesses have nothing to do with one another does not get you out of the responsibility to cover those employees. In that case, it probably would not make financial sense to adopt either the Solo 401(k) or the SEP-IRA. It would just not be cost effective.