Should I use a Sep IRA or a Solo 401k: A Guide for Independent Contractors

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model-t For most people, the simple truth of why we work is so that one day we won’t have to anymore. That is why it is so important to pick a retirement savings plan that will maximize the amount you can put away, and save you the most taxes in the long run.

One of the benefits of being an independent contractor is having more retirement plan options at your disposal. In addition to a traditional IRA and a Roth IRA, you have 2 noteworthy options: SEP IRA and a Solo 401(k).


SEP IRAs (Simplified Employee Pension Individual Retirement Account) work essentially like a traditional IRA. That is, you are allowed to deduct any contributions you make from your gross income when calculating your adjusted gross income. As a self-employed person without any employees, there isn’t a significant administration cost, but If you do have employees, they must all receive the same benefits under a SEP plan.

For 2015, if you have a SEP, you are allowed to contribute 25% of your net earnings from self-employment. However it is important to note, if you are the owner and employee of an S corporation, you are only able to contribute based on your salaried income, as any money must come from compensation as earned income, and distributions are not considered earned income by the IRS. This is the primary reason we recommend a Solo 401(k) for S corp owners.


Solo 401(k)
First, we want to point out that you can (probably) contribute much more to a Solo 401(k) than with a SEP IRA. A Solo 401(k) plan functions 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. You are allowed to make:
• An employee contribution of 100% of your net earnings from self-employment or W-2 income (as the owner and employee of an S corporation), up to $18,000 for 2015 ($24,000 if you are 50 or over)
• An employer contribution of 25% of your net earnings from self-employment, or W-2 income (if you are the owner and employee of an S corporation.)
• A spouse can also contribute to the Solo 401(k) separately, essentially doubling the annual contribution limit.

If a spouse wants to contribute to the Solo 401(k), they must earn compensation from the business. The spouse is then allowed to make separate contributions equivalent to their compensation.
It is also important to note that because you are in the role of the employer in addition to employee, you can make a larger contribution, as compared to just being a W-2 employee in most cases. Employers often put a limit on the matching contribution they provide, that is usually lower than the federal limit.

Also, any contributions made allows you to make an above-the-line deduction on your taxes, which helps when determining your AGI. This can be helpful to decrease your taxable income and perhaps even push you into a lower tax bracket.


Solo 401(k): Roth option
If you would prefer, you can make Roth contributions to a solo 401(k) rather than traditional (pre-tax) contributions. It’s important to note that only the employee contributions can be Roth contributions. Employer contributions must be made as traditional contributions.


Bottom Line
“Should I use a SEP IRA or a Solo 401k?” is a question we hear every day, the answer is, at the end of the day, if you own an S corporation, your best option is a Solo 401(k) as you can maximize contributions to your retirement plan. A Solo 401(k), by having two factors to make up your contributions, avoids the need to increase your salary, maximizing your tax savings even more by lowering your taxable income and minimizing your self-employment taxes.

The reason you wouldn’t want to open a SEP IRA is because your W-2 wages determine how much you can contribute. If you were to increase your salary for the purpose of increasing your SEP IRA contribution amount, you would be increasing the amount of income subject to self-employment taxes.

Let’s take a look at the example below. An Independent Contractor’s business net income is $100,000, has an S Corp and is paying himself a salary of $40K/year. He is trying to figure out where to invest. Here are scenarios that show how he would benefit from each option.

sep ira vs solo 401K

Independent Contractor Tax Advisors specialize in developing tax strategies specifically for independent contractors and self-employed. Contact us today for a free tax consultation and find out how we can help you save taxes and headache!


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