Retirement Savings 101: Self-Employment Options

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Question: I am a self-employed consultant with no employees. Do you suggest an individual 401(k) or a SEP IRA for my retirement savings?


Weighing My Options

Dear Weighing My Options,

The simplified employee pension (SEP) plan and individual 401(k) plan both are advantageous for self-employed business owners. But I typically recommend the individual 401(k). It‘s more flexible and carries a more powerful tax savings punch.

With both plans you can vary your contributions from year to year. But only the individual 401(k) (also known as a “solo 401(k) “) offers you the option to defer the first $16,500 of income. Despite the name, if your spouse also earns an income, double that savings to $33,000. And if you‘re 50 or older, add an extra $5,000. Unlike the SEP, which only allows tax-deductible savings, an individual 401(k) allows you to save this money in a traditional pre-tax or Roth after-tax account that comes out tax free in retirement.

Both the SEP and the solo 401(k) allow for contributions up to 20% of qualified income (for sole proprietors) or 25% of W-2 income (for corporations). That‘s a total reduction of taxable earnings of $49,000 for those younger than 50.

The difference is apparent when you look at a 40-year-old who has $100,000 of W-2 income. The SEP allows a deductible $25,000 contribution, whereas the individual 401(k) permits a much larger contribution of $41,500 ($25,000 + $16,500).

A SEP does not require the same annual reporting. But these days custodians like Charles Schwab provide this service without a fee. Additionally, the 401(k) has a loan provision, allowing employers to borrow from their accounts if necessary.

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Matthew Illian was a Wealth Manager at Marotta Wealth Management from 2007 to 2016. He specialized in small business consulting, college planning, and retirement plans.