401k Self Employed Retirement Plan
In this month where we celebrate Valentine’s Day, I would like to give some love to two under-appreciated retirement plans: (1) the Simplified Employee Pension (SEP), and (2) the Solo 401(k). Both are available to any person who generates income from self-employment.
Simplified Employee Pension (SEP)
SEPs are supercharged IRAs, following the same rules but allowing for higher contributions. In 2019, the self-employed can contribute the lesser of: (a) $56,000, or (b) 20% of their net adjusted income (gross income from self-employment minus expenses and half of one’s self-employment tax).
SEPs are easy to set up and administer. You can download Form 5305-SEP from the IRS’s website, or you can get the form from your financial advisor. You do not even have to send the form back to the IRS—simply file it in your records. Most mutual-fund companies, brokerage houses, and insurance companies offer prototype SEPs. You can invest your SEP in stocks, bonds, funds, CDs, etc.
You can also make contributions to your SEP until you file your taxes, including extensions. Therefore, someone eligible for an extension can open an SEP for 2019 upon filing tax returns in October of 2019.
SEPs are also flexible. You can change the amount you invest in your SEP from year to year, and some years you can decide not to fund it at all. Contributions are 100% tax deductible; they grow tax-deferred. However, they are taken above the line and cannot be Schedule C deductions, which means you save on income taxes but not self-employment taxes.
Self-employed individuals who want to save more than 20% on taxes should look into the Solo 401(k), which allows them to put in the 20% plus an additional $19,000 of employee contributions. Moreover, people aged 50 or over can add another $6,000. A spouse who draws a salary can also contribute.
People aged 50 or over with a net adjusted income of $100,000 can contribute $20,000 to an SEP. However, if they open a Solo 401(k), they could contribute the $20,000, plus the $19,000 of employee contribution, plus another $6,000 in age 50 catch-up, for a total of $45,000.
There is a limit, though. In 2019, that number is $56,000. However, catch-ups do not apply, so people aged 50 or over with enough income can contribute $62,000. One thing to keep in mind: the $56,000 number is per employer, while the employee limit is per person. So if you have more than one job from which you contribute to a retirement plan, the most you can do in total is $19,000 and if age fifty or over, the $6,000 catch-up. You can add a Roth component to a Solo 401(k); that way, some or all of the employee portion of your contribution ($19,000) can go into a Roth account.
Setting up a Solo 401(k) does require a little more in paperwork than an SEP. And once the assets in the plan reach $250,000, every year you have to file Form 5500 EZ with the government. But Form 5500 EZ is only a two-page form.
The deadline for establishing a Solo 401k is December 31 of the year in which you would like to receive the tax deduction. However, you can fund the employer portion (the 20% or less) until you file your taxes, including any extensions.
Also, with the Solo 401k you have the ability to access money tax-free using a Solo 401k loan. You can borrow 50% of the total 401k value, up to a $50,000 maximum. IRS rules do not allow loans with an SEP IRA.
Self-employment can be risky. But it can be made less so with sufficient retirement-saving options.
These are the opinions of Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only and should not be construed or acted upon as individualized investment advice.
Independent Contractor, Sole Proprietor, LLC Taxes, Mike Piper CPA, Kindle Addition
Both examples assume no additional employees. If employees are part of the mix the rules get complicated.