SEP vs. SIMPLE vs. Solo 401(k)

(The following is an excerpt from my book Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)

One of the biggest benefits of being self-employed is that there are more (and better) retirement plan options available to you than are available to most taxpayers. In addition to the standard traditional IRA/Roth IRA options that everybody has, you have three more noteworthy options:

1. Simplified Employee Pension (SEP IRA),
2. Savings Incentive Match Plan for Employees (SIMPLE IRA), and
3. Individual 401(k) — sometimes called a solo 401(k) or a self-employed 401(k).

Much of the IRS literature comparing these three options is rather complicated. Fortunately, most of that literature is irrelevant if you have no employees. If you have no employees, the primary difference between the plan options is the contribution limit for each. (Note: These limits are not cumulative, so there’s usually no benefit to opening more than one retirement plan for your business.)

If you do have employees and you want to set up a retirement plan for your business, I strongly recommended that you consult with a tax professional, not only because there are additional factors in the decision of which plan to open, but because there are ongoing reporting and nondiscrimination requirements as well.

I should also note here that there are several other types of retirement plans aside from the three listed above. But for self-employed taxpayers without employees, it’s uncommon for any of the other types of plans to be a better choice.

Retirement Plans in General

Most of the retirement plan options for self-employed taxpayers function similarly to a traditional IRA. That is, contributions made to the plan reduce your taxable income, and your investments are allowed to grow tax-deferred until you start making withdrawals from the plan. Unfortunately, contributions are adjustments to income (i.e., “above the line” deductions) rather than Schedule C deductions, meaning they save you money on income tax but not self-employment tax.

SEP IRA

SEP IRAs work in almost the exact same way as a traditional IRA. That is, you are allowed an adjustment to income for any contributions you make, and distributions from the account are taxable as income. The only really important difference is the contribution limit. For 2021, if you have a SEP, you are allowed to contribute the lesser of:

1. 20% x (your business’s profit, minus the deduction for one-half of your self-employment tax), or
2. $58,000.

Once the money is in the plan, you can invest it in all of the same things you would be allowed to invest in with a regular IRA (stocks, bonds, mutual funds, CDs, etc.). Also, the same withdrawal rules apply. With a few exceptions, you cannot make withdrawals from the plan prior to age 59.5 without being penalized.

EXAMPLE: Your business’s profit for the year is $100,000, and your deduction for one-half of your self-employment tax is $7,065. Assuming you do not contribute to another retirement plan for your business, your annual SEP contribution will be limited to $18,587, calculated as 20% x ($100,000 — $7,065).

SIMPLE IRA

SIMPLE IRAs also function much like traditional IRAs. Again, the primary difference is the contribution limit. If you have a SIMPLE IRA, you can make:

1. An employee contribution of $13,500 for 2021 (plus an employee catch-up contribution of $3,000 for 2021 if you are age 50 or over), limited to 100% of your net earnings from self-employment, plus
2. An employer contribution equal to 3% of your net earnings from self-employment.

For SIMPLE IRA purposes, “net earnings from self-employment” is your business’s profit, times 92.35% (to approximately account for your deduction for one-half of your self-employment tax).

EXAMPLE: You’re under 50 years old, and your net earnings from self-employment is $50,000. Assuming you don’t contribute to any other retirement plans, the most you’ll be able to contribute to a SIMPLE IRA is $15,000 ($13,500, plus 3% of $50,000).

One other difference between a SEP IRA and a SIMPLE IRA is that, should you have to make an early withdrawal from a SIMPLE IRA within two years of the plan’s inception date, you will be penalized more than you would be if it were a SEP IRA (25% penalty as compared to 10% penalty).

Individual 401(k) Plans

An individual 401(k) plan functions very much like a 401(k) plan with a person’s employer. The difference is that you are allowed to make a contribution in the role of employee and a contribution in the role of employer. Specifically, you are allowed to make:

1. An employee contribution of $19,500 for 2021,
2. An employer contribution equal to 20% of your net earnings from self-employment, and
3. A catch-up contribution of $6,500 for 2021 if you’re age 50 or older.

In this case, your net earnings from self-employment is defined as your business’s profit, minus the deduction for one half of your self-employment tax.

However, there are a few additional limitations to the above contributions. Specifically:

• The employer contribution is limited to half of the difference between your net earnings from self-employment and the employee contribution,
• The employee and employer contributions are limited to a combined total of (for 2021) $58,000, and
• The total contribution is limited to your net earnings from self-employment.

Also, as we’ll discuss shortly, if you have another job (i.e., a “day job”), your maximum employee contribution and catch-up contribution will be affected if you make contributions to a retirement plan at that other job.

There’s obviously a lot going on here. Fortunately, you can use the “Deduction Worksheet for Self-employed” from IRS Publication 560 to walk you through the math. I’ve also made a solo 401(k) calculator that you can use.

EXAMPLE: You’re under 50 years old, and you have a business with no employees. Your net earnings from self-employment are $100,000 for 2021. If you have an individual 401(k) plan (and no other retirement plans to which you’re contributing), your contribution limit will be $39,500 calculated as follows:

• Employee contribution of $19,500, plus
• Employer contribution of $20,000 (20% of $100,000).

If you had a SEP IRA instead, your contribution would be limited to $20,000 (20% of $100,000). Alternatively, if you have a SIMPLE IRA, your contribution limit would be even lower ($13,500 plus 3% of net earnings from self-employment).

The conclusion here? In most circumstances you can contribute more — sometimes much more — to an individual 401(k) than you could contribute to a SEP IRA or SIMPLE IRA.

(For more information, see the book on Amazon: Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)

Individual 401(k): Roth Option

In addition to usually allowing for greater contributions, individual 401(k) plans have another benefit: If you would prefer to do so, you can make Roth contributions to an individual 401(k) rather than pre-tax (“traditional”) contributions.

Note, however, that many brokerage firms do not allow for this option, so be sure to check with the brokerage firm you’re considering if it’s important to you to be able to make Roth contributions.

If you decide to open an individual 401(k) with a Roth option, it’s important to know that only the employee and catch-up contributions (those limited to $19,500 per year and $6,500 per year for people 50 or older) can be Roth contributions. The employer contributions must be made as traditional, tax-deferred contributions.

Is an Individual 401(k) Always Best?

Given the dual advantages of Roth contribution capability and (usually) higher contribution limits, one might wonder why anybody would choose a SEP or SIMPLE IRA over an individual 401(k).

Previously, a significant disadvantage to individual 401(k) plans was that they came with higher administrative costs. Over the last several years though, price competition has brought costs down considerably at some brokerage firms. For example, Fidelity’s individual 401(k) has no set-up or administrative costs at all. Similarly, Vanguard’s individual 401(k) has no set-up fees and only a modest administrative fee: $20 per year for each mutual fund in the plan — and this fee is waived if you have at least $50,000 of assets with Vanguard.

Given the decline in costs, the only real remaining drawback is paperwork. Setting up an individual 401(k) will likely require you to fill out more forms than opening a SEP or SIMPLE IRA. In addition, individual 401(k) plans require  you to file Form 5500-EZ with the IRS every year once the plan reaches $250,000 in assets.

Deadlines for Retirement Plans

A SEP IRA or individual 401(k) can be set up as late as the due date (including extensions) for the business’s tax return for the year. The deadline for contributions is the same date. For a sole proprietor, this means that you can set up the plan and make contributions for a given year as late as April 15 of the following year (or October 15 of the following year if you filed for an extension).

Assuming you’ve never had one before, a SIMPLE IRA can be set up as late as October 1 of the first year for which you wish to make contributions. (If you have had a SIMPLE IRA before and are setting up another one, you must set it up by January 1 of the first year for which you wish to make contributions.)

For a sole proprietor, the deadline for SIMPLE IRA employee contributions is January 30 of the following year. The deadline for the employer contribution is the due date (including extensions) for the business’s tax return for the year (i.e., April 15 of the following year, or October 15 if you filed for an extension).

What if You Have Other Retirement Accounts?

Given that you now have so many different options available to you, it’s important to know how each of these plans interacts with other retirement accounts. None of the above-mentioned plans will affect your ability to contribute to a traditional or Roth IRA. They could, however, affect your ability to claim a deduction for a contribution to a traditional IRA, because if you have one of the business retirement plans described above, you are considered to be covered by a retirement plan at work, which means that if your adjusted gross income is over a certain amount, you will not be able to claim a deduction for a traditional IRA contribution.

In addition, if you have another job as an employee and you are allowed to contribute to a 401(k) at that job, contributions you make to your plan at work — to take advantage of an employer matching contribution for instance — will count against the limit for employee contributions to an individual 401(k) or SIMPLE IRA. And the same goes for catch-up contributions. (That is, catch-up contributions made to your plan at work will count against the catch-up contribution limit for your individual 401(k) or SIMPLE IRA.) And it works in the other direction too — employee and catch-up contributions you make to an individual 401(k) or SIMPLE IRA will count against the contribution limits for your plan at work.

EXAMPLE: Jan is 40 years old and has a full-time job that offers a dollar-for-dollar match for contributions she makes to her 401(k), up to $4,000. She also has a part-time business for which she has an individual 401(k). Her net earnings from self-employment are $40,000.

To get the maximum match from her employer, she contributes $4,000 to her 401(k) at work. The maximum employee contribution she can make to her individual 401(k) for the year is $15,500 ($19,500 — $4,000). In addition, she can make an employer contribution of up to $8,000 (20% of her net earnings from self-employment).

Simple Summary

• As a business owner, you have several options for retirement plans. In most cases, contributions to these plans reduce your taxable income.
• In most cases, an individual 401(k) plan will allow for the largest contribution. In addition, individual 401(k) plans allow for Roth contributions (though this is not available at all brokerage firms).
• SEP IRAs and SIMPLE IRAs, however, can sometimes be good choices because of their simplicity.