If you are self-employed, you may be eligible to open an individual 401(k) or SEP-IRA and make tax-advantaged contributions to the account. An individual 401(k) plan may also be referred to as a solo 401(k) or single-participant 401(k).
Both an individual 401(k) and a SEP-IRA may allow for more tax-advantaged contributions than a traditional IRA. The differences between the two plans are discussed below. The advantages and disadvantages listed are not intended to be all-inclusive, and you should consult your tax advisor before opening any new account.
Individual 401(k)
Advantages
- An individual 401(k) may allow for more contributions than a SEP-IRA. The reason is that contributions can be made as an employer (similar to the SEP-IRA) AND an employee. The employee limit is the same as an employee in a traditional 401(k), and the limit generally changes every year. The employee limit is aggregated across all plans. For example, if you participated in another 401(k) plan, any employee contributions you made to that separate plan must be factored in when determining how much you could make as an employee to your individual 401(k). For more information on employee and employer limits, please visit the IRS website discussing individual 401(k)s.
- An individual 401(k) may also allow for Roth contributions, which are unavailable in a SEP-IRA.
Disadvantages
- Individual 401(k)s may require more initial as well as ongoing paperwork.
- Contribution limits are more complex than SEP-IRAs since both employer and employee contributions are allowed.
- Individual 401(k)s may only cover a business owner with no employees, or that person and his or her spouse. If other employees become eligible, then the plan may become subject to nondiscrimination testing.
SEP-IRA
Advantages
- A SEP-IRA may be easier to set up and require less paperwork than an individual 401(k).
- Contributions are generally easier to determine as compared to contributions related to individual 401(k)s. For more information on the employer contribution limits for SEP-IRAs, please visit the IRS website discussing SEP-IRA contributions.
- SEP-IRAs are not subject to nondiscrimination testing even if additional employees are hired and become eligible.
Disadvantages
- SEP-IRAs may not allow for the same level of contributions as an individual 401(k). This is because a SEP-IRA does not allow for an employee contribution.
- SEP-IRAs do not allow for Roth contributions.
- If additional employees are hired and covered by the SEP-IRA plan, you will likely need to contribute the same percentage of salary to all employees' SEP-IRA accounts.
Disclosures:
You should consult with your tax advisor before opening any new accounts.
Please note that higher tax-deferred balances could result in higher required minimum distributions (RMDs) in retirement. This should be considered when implementing any new account recommendations or other such strategies that seek to optimize across tax-exempt, tax-deferred, or taxable accounts. If you are seeking to minimize RMDs, a contribution strategy that recommends a higher tax-deferred balance in your portfolio may not be appropriate. Please consult your tax advisor when implementing any strategy that attempts to lower income taxes.
Nothing herein should be interpreted as tax advice. ComposedPro does not represent in any manner that the tax consequences described herein will be obtained or result in any particular tax consequence. Please consult your personal tax advisor as to whether opening an account is a suitable strategy for you, given your particular circumstances. You and your tax advisor are responsible for how transactions conducted in your account are reported to the IRS on your personal tax return. ComposedPro assumes no responsibility for the tax consequences to any client of any transaction.
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