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, gain additional options, as well as operate a more cost-effective retirement plan than a SEP IRA.
There are a number of options that are specific to Solo 401(k) plans that make the Solo 401(k) a far more attractive retirement option for a self-employed individual or small business owner than a SEP IRA:
1. Reach your Maximum Contribution Amount Quicker: A Solo 401(k) includes both an employee and profit sharing contribution option, whereas, a SEP IRA is purely a profit sharing plan. Under the 2015 and 2016 Solo 401(k) contribution rules, a plan participant under the age of 50 can make a maximum employee deferral contribution in the amount of $18,000. 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 $53,000.
For plan participants over the age of 50, an individual can make a maximum employee deferral contribution in the amount of $24,000. 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 $59,000.
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 $53,000 for 2015. No employee deferral exists for a SEP IRA.
For example, B, who is 60 years old, owns 100% of an S Corporation with no full time employees. Ben earned $100,000 in self-employment W-2 wages for 2015. If Ben had a Solo 401(k) Plan established for 2015, B would be able to defer approximately $49,000 for 2015 (a $24,000 employee deferral, which could be pre-tax, after-tax or Roth, and 25% of his compensation giving him $49,000 for the year). Whereas, if B established a SEP IRA, B would only be able to defer approximately $25,000 (25% if his compensation) for 2015.
2. No catch-up Contributions: With a Solo 401(k) you can make a contribution of up to $53,000 to the plan each tax year ($59,000 if the participant is over the age of 50) in 2015 and 2016. However, with a SEP IRA, the maximum amount that can be deferred is $53,000 since a SEP IRA does not offer any catch-up contributions.
3. No Roth Feature: A Solo 401(k) plan can be made in pre-tax, after-tax or Roth format. Whereas, in the case of a SEP IRA, contributions can only be made in pre-tax format. SEP IRA contributions can then be converted to a Roth IRA, but the initial SEP IRA contribution must be in pre-tax. In addition, a contribution of $18,000 ($24,00, if the plan participant is over the age of 50) can be made to a Solo 401(k) Roth account directly.
4. Tax-Free Loan Option: With a Solo 401(k), assuming your plan documents allow for it, you can borrow up to $50,000 or 50% of your account value, whichever 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), you can make a real estate investment using a nonrecourse loan without triggering the Unrelated Debt Financed Income Rules and the Unrelated Business Taxable Income (UBTI or UBIT) tax (Internal Revenue Code Section 514). However, the nonrecourse leverage exception found in Internal Revenue Code Section 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 involving nonrecourse financing would trigger the UBTI tax, which could be close to 40 percent.
A SEP IRA can still be a very useful and attractive retirement plan for many small businesses for a number of reasons, including:
1. Flexible Timing of Contributions: A SEP IRA can be adopted at anytime prior to the filing of the employer’s tax return, including extensions, whereas, a Solo 401(k) plan must be adopted by December 31 of the taxable year in which the contributions will be made. This offers some flexibility and allows some to make retirement account contributions after December 31 of the taxable year in question.
2. 3-5 Rule: With a SEP IRA, an employer can get around having to make employer profit sharing contributions to an eligible employee and requires the employer to only make SEP IRA contributions to employees who have worked for the employer in at least 3 of the last 5 years (3-5 year rule). The 3-5 year rule allows a employer some flexibility and potential cost savings when contemplating making SEP IRA employer contributions, whereas, with a 401(k) plan, any employee that works at least 1000 hours and has been with the employer for at least 1 year would generally be eligible to participate in a 401(k) plan.
Overall, it is still surprising that so many SEP IRAs are being established and maintained by the self-employed in light of the many advantages of a solo 401(k) plan. According to the January 2015 ICI Research Perspective publication, in mid-2014, 6.0 percent of U.S. households owned employer-sponsored IRAs, which include SEP IRAs, SARSEP IRAs, and SIMPLE IRAs. Both a SEP IRA and Solo 401(k) plan can be established for free with most banks and financial institutions and both have very little administration requirements, however, the Solo 401(k) plan offers so many more features than the SEP IRA, such as employee deferrals, loan feature, and Roth option making it, in most cases, the best retirement option for the self-employed and small business owner.
Both the SEP IRA and Solo 401(k) plan offer exciting retirement benefits for the self-employed and small business owner, but the truth is more and more business owners should probably think about going solo.