Solo 401(k) vs. SEP-IRA for S Corporation Owners

As an S corporation owner, you wear many hats. You're the CEO, the marketing team, the janitor – and, most importantly, your own chief financial officer. That means when it comes to retirement planning, you've got some decisions to make. Two popular options are the solo 401(k) and the SEP-IRA, each offering unique advantages and tax implications. Let's dive into the details:

Contribution Limits:

• Solo 401(k): You can contribute as an employee (up to $22,500 in 2023, plus $7,500 catch-up if over 50 for a total of $30,000 for employee contributions) and as an employer up to 25% of employee compensation (W2 compensation) capped at a combined grand total employee plus employer contributions of $66,000 ($73,500 if age 50 or older). Note, S corporation income is not self-employment income so Solo 401(k) applicable to self-employment income is not discussed for this purpose.

• SEP-IRA: A Simplified Employee Pension (SEP) plan provides business owners with a simplified method to contribute toward their employees’ retirement as well as their own retirement savings. You can contribute up to 25% of employee compensation (W2 compensation) capped at $66,000 in 2023 per eligible employee.

Tax Advantages:

• Solo 401(k): Both employee and employer contributions are eligible for pre-tax deductions (if the plan is a ROTH Solo 401(k) then only the employer portion will be eligible for a pre-tax deduction), meaning they immediately lower your taxable income. All earnings grow tax-deferred until withdrawn in retirement.

• SEP-IRA: Employer contributions are immediately tax-deductible and in essence provide the same tax advantage of lowering your taxable income. Employee contributions (your own) are not applicable; the full 25% of employee compensation is contributed by the employer. Earnings on the entire balance also grow tax-deferred.

Flexibility:

• Solo 401(k): Offers more loan and hardship withdrawal options. You can also choose from a wider range of investment options.

• SEP-IRA: Generally less flexible. Loans are typically unavailable, and hardship withdrawals are subject to stricter rules. Investment options may be limited.

Administrative Ease:

• Solo 401(k): More paperwork and filing requirements, especially if you offer loan options. The plan must also be established prior to the end of the tax year for which the tax benefits are to be taken. Contributions to the plan can be made in the following calendar year by the tax filing deadline but the plan must already be established.

• Solo 401(k) is only limited to single owner/employee businesses with the exception of including your spouse as an owner/employee also.    

• SEP-IRA: Simpler setup and administration. The plan can be established after the applicable tax year end and contributions can be made after the applicable year end also. The plan only has to be established and funded by the tax filing deadline (extension included). Simply contact your brokerage firm to get an account set up.  

• SEP-IRA is not limited to only single owner/employee businesses; other personnel are also allowed to be employed as employees and also participate in the plan.

Choosing the Right Option:

The best choice depends on your individual circumstances. Consider these factors:

• Contribution limits: If you are looking for overall higher contribution limits, then the Solo 401(k) plan may be more appealing.

• Simplicity: If you prefer a plan that is easy to set up, low administrative costs, no discrimination testing required, then you may prefer the SEP-IRA plan.

• Flexibility: If you value loan access and investment control, the solo 401(k) might be worth the extra paperwork.

• Employees: If you have employees other than yourself, then the SEP-IRA may be your only option between the two.

What if you are under age 50 in which the applicable max contribution limit is $66,000 for both Solo 401(k) and SEP-IRA plans and all other factors are equal, which would be your best option?

Well, with the Solo 401(k) you can contribute up to 100% of your employee compensation but capped at the 401 (k) employee contribution limit of $22,500. The remainder of the $43,500 ($66,000 total combined) would have to come from an employer contribution of 25% of the employee compensation. So, roughly speaking, the ideal employee compensation would need to be $174,000 in order to cost-effectively contribute the full max contribution of $66,000. Keep in mind, the higher the W2 compensation the higher your payroll taxes (FICA and Medicare) so you wouldn’t want to jack up your W2 compensation higher than necessary to reap the max contribution benefits. And, as a reminder, as an owner-employee you are responsible for paying both the employee and employer payroll taxes out of your pocket.

Now, let’s look at the SEP-IRA – you’d need W2 compensation to be about $264,000 in order to contribute the full max contribution of $66,000. No way! Why?? I bet the Solo 4014(k) looks a whole lot better in this case doesn’t it.  

Remember, this is just a high-level overview. As a tax professional, I recommend consulting with me to analyze your specific situation and determine the plan that best optimizes your tax savings and retirement goals. Don't let the alphabet soup of 401(k)s and IRAs keep you from saving for your golden years!

Disclaimer: This article is for general informational purposes only and does not constitute legal or tax advice. Also consider consultation with a professional, licensed, and experienced personal financial advisor.

For further discussion on this topic and more visit us online at https://www.sve-accountingandtaxes.com/make-appointment/

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