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YOUR MONEY
Retirement
Plan Options For The Self-Employed:
Solo 401(k)s vs. SEPs
(Part three of a series on retirement planning.
In previous installments of this series we examined defined
benefit plans and matching and Safe Harbor 401(k)s. This month
we take a look at Solo 401(k)s and SEPs.)
Experts estimate that Americans will need 60 to 80 percent
of their pre-retirement income to maintain their current standard
of living when they stop working. If you are the sole owner
of a small business, pension plans are a great way to build
wealth to ensure that you can retire comfortably. They are
also great tax-saving tools that can benefit your business
today.
The two most common retirement plans available to the sole
owner are the more traditional SEP (Simplified Employee Pension
plan) and the Solo (Self-Employed) 401(k) that was introduced
in 2001 under the Economic Growth and Tax Relief Reconciliation
Act (EGTRRA).
Deciding which retirement plan is right for you can be confusing.
Which would be better for you: a SEP or a Solo 401(k)?
The Solo 401(k)
The Solo 401(k) is a plan designed to accept employee
salary deferral contributions plus a profit sharing portion.
(See part
two of this series.)
This means for 2007, the Solo 401(k) allows a self-employed
person to make a contribution of 25 percent of earned income
(net profit from your Schedule C minus one-half of self-employment
tax minus the contribution), plus salary deferrals of $15,500
with a maximum contribution not to exceed $45,000. Individuals
50 and older can make an additional $5,000 catch-up contribution
and invest a maximum $50,000.
The SEP
The SEP, on the other hand, only allows you to contribute
the profit sharing portion. The Internal Revenue Code for
2007 allows the same maximum contribution of $45,000 or $50,000
for those 50 and older. Let’s look at some examples
to clarify the differences between these plans.
Jane is 54 years old and runs a one-person business, a one
member LLC consulting firm. This is how the contributions
to her Solo 401k Plan could look if she has $100,000 in profits
in 2007:
Maximum Profit Sharing
Contribution |
$18,587 |
Maximum salary deferral
to 401(k) |
$15,500 |
Maximum catch-up deferral
to 401(k) |
$5,000 |
Total |
$39,087 |
If Jane had a SEP the maximum contribution
to her 2007 pension would be $18,587, which only includes
the profit sharing portion.
The above example is for a single owner who is either a
sole proprietor or single member LLC.
If Jane had an incorporated business, the numbers would
change slightly because the self-employment taxes would
be paid by the corporation in her W-2. She could contribute
the following to her Solo 401(k):
Profit Sharing (25%
of $100,000) |
$25,000 |
Salary Deferral Contribution
to 401(k) |
$15,500 |
Catch-up contribution
to 401(k) |
$5,000 |
Total |
$45,500 |
If Jane’s incorporated business
sets up a SEP only the profit sharing portion, or $25,000
in this case, could be contributed to her pension plan.
So, the bottom line is those of you who are savvy will set
up the Solo 401(k) to take advantage of every tax break
available, and create the greatest amount of wealth. You
also will not have to worry about future years when cash
might be tight, because you will not have to contribute
the maximums, or anything at all, if you so choose. In other
words, the Solo 401(k) lets you make larger contributions
in profitable years while giving you the freedom not to
make lower contributions in less profitable years or when
cash flow is tighter.
If you wish to contribute more than 25 percent of earned
income then a Solo 401(k) is definitely for you. Otherwise,
a SEP may be sufficient. As you start nearing $225,000 of
earned income the difference between one plan type and the
other shrinks because, in both cases, you’re approaching
the contribution maximums. Setting up a Solo 401(k) is generally
a little more expensive and requires slightly more paperwork
than a SEP. However, the benefit almost always outweighs
the small cost difference.
It’s important to note that you must set up a Solo
401(k) by December 31st of this year. A SEP can be set up
after year-end and before you file even if you request extensions.
Guy McPhail, CPA, CFP®,
is president of Zdenek Financial Planning, LLC.
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