Comparing the Solo(k) and SEP-IRA for the Self-Employed

For those who are self-employed, the question of how to save for retirement is a frequent one. Fortunately, the answer isn’t all that difficult.

Establishing a retirement plan as a self-employed individual can be easy. In fact, it can be easy AND more advantageous than a typical employer-sponsored 401(k) plan.

This is because as the employee/owner of the company, you can choose a retirement plan that fits your specific wants and needs.

Looking to keep things simple and straightforward? There is an answer for that.

Looking to max fund a plan as quickly as possible? There is an option for that, too.

Ultimately, the final decision on which retirement plan you choose will reflect your wants, needs, income, structure, growth, employees, and so on.

So while the options are plenty, the final decision takes a bit more consideration.

From Employee to Employer

As an employee, your retirement savings options may be limited by how much you (and your family) make and whether or not your company offers a retirement plan. The combination of these rules impacts how much you can contribute to a plan.

One of the more common retirement saving vehicles for employees is the 401(k) plan.

On the surface, the 401(k) plan is straightforward (at least for an employee).

Upon becoming eligible for the plan, an employee can defer from payroll into a plan. It’s simple – once it has been decided how much to contribute to the plan, the employee completes the paperwork, and the company processes the deferral.

(The ease with which this happens is one of my favorite features of a 401(k) plan.)

Furthermore, some employers encourage you to participate in the plan by offering company match and/or a profit share contribution.

Retirement Plans for the Self-Employed

As you transition from employee to self-employed business owner, the retirement savings world changes. You go from being force-fed a retirement plan offered by your employer, to choosing which retirement plan suits you best.

At your immediate disposal are several options.

Which one you choose depends on a number of considerations. How much you make. Your business structure (Schedule C or S-Corp). How many employees you have. Expected changes in the business. Annual funding goals. And how easy or hard you want the plan’s administration to be.

For the purposes of today’s discussion, we will focus on retirement plans for self-employed individuals with zero employees. Basically, a one-person company. You!

Earned Income vs. Wages

The maximum annual retirement contribution you as a self-employed person can make is subject to how much income you earn and what type of retirement vehicle you are funding. Furthermore, these income calculations are dependent on your company structure. Commonly, structure is divided into two camps.

  1. Income that is reported on Schedule C of a personal tax return
  2. Income from an S-Corp in the form of wages and a dividend

While these individual structures have benefits and drawbacks, the scope of why one is right or wrong is a discussion for a different day.

What is important today is to know that with both a Schedule C and an S-Corp, the business owner has the option of implementing a SEP-IRA or a Solo(k) for retirement savings.

Maximum SEP-IRA Contribution

A SEP-IRA is simple and straightforward, and the amount a business owner can contribute is high. In fact, a business owner can contribute up to 25% of his/her earned income up to an annual maximum contribution of $53,000 (in 2016).

Additionally, a SEP-IRA may be attractive thanks to low administration expenses and ease of operation. However, what is gained in ease of administration is lost in contribution flexibility.

Using a hypothetical example, we can illustrate the maximum funding for a SEP-IRA based on various income levels and company structures. Let’s explore:

The chart below illustrates the maximum allowable contribution (25%) to a SEP-IRA assuming the various wages. The simplifying assumption in our hypothetical example is that $100,000 is the net Schedule C income and $100,000 is the S-Corp W2 wage.

$100,000 $150,000 $200,000
Schedule C $18,587.05 28,128.88 $37,994.97
S-Corp $25,000 $37,500 $50,000

 

Without detailing the specific calculations, you can see that the S-Corp allows for higher annual retirement plan contributions compared to a Schedule C, assuming the same wage.

Solo(k) and Profit Sharing Plan

A second option for the self-employed business owner is a Solo(k) and profit sharing plan.

A Solo(k) has additional features compared to its SEP-IRA counterpart, including higher contribution rates at lower income levels and the option for a ROTH 401(k) component. For this tradeoff in options, a Solo(k) and profit sharing plan have increased administration costs and increased complexity.

Continuing our example from above:

Schedule C – Solo(k) and Profit Sharing Plan

$100,000 $150,000 $200,000
401(k) Deferral $18,000 $18,000 $18,000
Catch up (age 55+) $6,000 $6,000 $6,000
Profit Share $18,587.05 $28,128.88 $37,994.97
Total $42,587.05 $52,128.88 $59,000

 

S-Corp – Solo(k) and Profit Sharing Plan

$100,000 $150,000 $200,000
401(k) Deferral $18,000 $18,000 $18,000
Catch up (age 55+) $6,000 $6,000 $6,000
Profit Share $25,000 $37,500 $50,000
Total $49,000 $59,000 $59,000

 

The rules regarding contributions to a Solo(k) are different than the SEP-IRA. Specifically, a business owner who implements a Solo(k) can defer from his/her salary up to $18,000 of earned income per year (plus an additional $6,000 if 55 years of age or older).

Simply stated – this deferral feature of the Solo(k) allows for a business owner to get money into the plan quicker than would be allowable via a SEP-IRA.

In addition to the $18,000 deferral, the business owner can add a profit-sharing component that allows him/her to contribute an additional 25% of earned income (for a total of $53,000, or $59,000 if 55 years of age or older).

Planning the SEP and Solo(k)

Comparing the SEP IRA to the Solo(k), we have illustrated that at lower wage levels, the Solo(k)/PSP substantially increases allowable annual contributions to a retirement plan.

A recap of the figures

SEP – Schedule C SEP – S-Corp Solo(k) – Schedule C Solo(k) S-Corp
$100,000 $18,587.05 $25,000 $42,587.05 $49,000
$150,000 $28,128.88 $37,500 $52,128.88 $59,000
$200,000 $37,994.97 $50,000 $59,000 $59,000

 

As you can see, at “lower” income levels, the spread between the maximum allowable contributions is significant.

Specifically, if we compare the SEP Schedule C to the Solo(k) Schedule C for someone making $100,000, we can see an increased contribution of $24,000.

As the income levels increase from $100,000 to $150,000 and $200,000, the advantage of the Solo(k) becomes less and less. At some point, the advantage may become so small that the cost of administration and the complexity of the 401(k) plan may not be worth the trouble.

Other Factors to Consider

Just like most topics in financial planning, a comparison of a SEP-IRA vs. a Solo(k) is difficult. In fact, a full analysis will require addressing additional questions like the following:

Ultimately, it is important to have an adequate understanding of the available options and how much you can save. Because the difference between saving $18,000 per year or $42,000 per year over the course of 10, 20, or 30 years is huge!

The above figures are for illustrative purposes only and do not attempt to predict actual results of any particular investment.

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3 Responses to Comparing the Solo(k) and SEP-IRA for the Self-Employed

  1. Hayworth February 22, 2017 at 12:17 am #

    Another great comparison of available options and the opportunity cost of each method for a commom and relevant scenario overlooked im sure by many. Not Dan Zajak CFP

  2. Matt Miller February 25, 2017 at 11:54 pm #

    Thanks Daniel! This post is super valuable and the detail you go into is great. The charts really help to break up the content. Self employed workers have some pretty good options.

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