SEP IRA and Solo 401k are the most preferred retirement plans for self-employed individuals and owner and spouse businesses since they offer higher contribution limits and flexible annual contributions. Between the two, Solo 401k allow greater annual contribution at identical income levels than SEP IRA since they are calculated annually; however, they do entail higher administrative responsibilities. Also, individuals are allowed to borrow against their retirement plan’s balance as collateral against the Solo 401k, this is not permitted with the SEP IRA.
Both SEP IRA and Solo 401k allow a maximum contribution of up to $51,000 annually, with Solo 401k; however, a person above the age of 50 years is allowed to contribute up to $56,000. This is where the similarities end.
We examine the differences between the two retirement plans.
What is it?
SEP IRA allows tax-deductible contributions and tax deferred growth with minimal paperwork. Solo 401k or Self-Employed 401k offer tax advantages similar to those offered by SEP IRA, but with more detailed paperwork and higher contribution limits.
The SEP IRA is more inexpensive when compared with Solo 401k though the 401k offers greater tax management flexibility and allows the investor to withdraw the investment amount in case of an emergency without any penalty. The Solo 401k allows the individual to save more for their retirement at a smaller income than the SEP-IRA.
Advantages of Solo 401k over SEP-IRA
Apart from the features mentioned above, there are numerous advantages that Solo 401k has over SEP-IRA:
• Roth Component: The Solo 401k rollover can be set up as a Roth component, which allows the investor to make deferrals after the tax money so that they can withdraw tax-free once retired.
• Custodian Fees: The Solo 401k does not require a custodian unlike the SEP-IRA, which as per law has to be held by a third-party custodian. The Solo 401k is kept under a trust of which the investor is appointed as the sole trustee. The investor is given the option to open a bank account in the name of the trust and use it as the investment vehicle and avoid paying a custodian fee.
• Loan: As mentioned above, an investor can borrow against their Solo 401k contribution. The maximum borrowing amount permitted is up to $50,000.
• Real Estate: The Solo 401k is not subject to the Unrelated Debt Financed income (UDFI), which is a tax liability that investment in real estate from retirement funds attracts. In this case, even the profits that are earned from the leverage will receive the tax deferred benefits of the retirement funds. This provision is not available with the SEP-IRA which attracts the UDFI.
• Prohibited Transactions: The Solo 401k attracts a 10% penalty on prohibited transactions with the plan remaining unaffected. In the case of SEP-IRA, besides the 10% penalty, prohibited transaction also attracts distribution of the account itself, which means the SEP IRA structure will be dissolved and any applicable taxes are due immediately.
While both the contributions offer major retirement and tax-saving benefits to self-employed individuals, the solo 401k is a better option for those who are seeking a faster route to maxing out their contributions.
