Guide for Self Employed Individuals Confused Between SEP IRA, Simple IRA and Solo 401(k)

IRA-Roth-401kBy: Rick Pendykoski

For a self employed individual there are a variety of retirement investment options to choose from. The three most popular ones are SEP IRA, Individual 401(k) Plan, and Simple IRA.

A Simplified Employee Pension (SEP) plan provides self employed people an easy way to contribute toward their own and employee’s retirement. It is a lot like a traditional IRA in terms of benefits. Your savings invested in a SEP-IRA grow in a tax deferred manner.

Under a SEP IRA, the owner can contribute as much as 25% of his net earnings from self employment up to a limit of $52,000.

A SEP IRA is one plan to consider when you are the sole owner of the firm and there are no employees to support. However the plan can get complicated and costly once qualifying employees come on board.  The same contribution percentage you choose for yourself must be adopted for each employee.  Qualified employees must be at least 21, earn at least $550 and have worked 3 of the last 5 years.

An attractive part of contributing to a SEP IRA is timing.  You can contribute any time you wish up to and including when you file your taxes including extensions. If your net income turned out to be more than you anticipated you have the choice to contribute a higher amount, thus lessening your taxable income. Conversely in a down year, you are not roped in at all – contribute what you can.

Individual 401(k) Plan
Since 2002 the Individual 401(k) is the most popular choice for self employed people and their spouses.   It is a less complex plan, allowing for a combination of personal deferrals and profit sharing.  Personal deferrals (contributions) can be up to $17,500 or $23,000 depending if you are fifty or over.  The personal deferral can be designated as Roth or Traditional or parts there of. The profit sharing adds another even more money into the plan.  Depending how your business is established, the profit sharing can be either 20 to 25% of the participant’s self-employed income. The sum of both contributions can be a maximum of $52,000 or $57,000 if you are over 50.

The best part of a solo 401(k) plan is that the contribution amount is optional. If you have generated healthy profits you can look to save the maximum amount allowed, while in lean years, you can even opt not to save anything.

Personal Loan – with a self directed 401 k plan, you have the ability to borrow up to 50% of your plan account balance with a dollar limit of $50,000.  It is a loan of course and has to be repaid but you can use the funds for any thing you wish.

Sometimes this type of plan is referred to as a Solo K.  This is a misnomer.  Spouses and partners can be part of the same plan.  There are so many advantages of a self directed 401 k v.s. Ira’s –  we always try to graduate our clients to this type of plan if possible.
This is a Savings Incentive Match Plan for Employees and is tailored for small businesses and self employed individuals. It is very easy to set up a SIMPLE IRA as it involves very little paper work. It is a great option for those businesses which have less than 10 employees and make more than $5,000. You can offer your employees this plan as an incentive or a perk.

In a SIMPLE IRA, an employee can contribute up to 100 percent of his earnings subject to a limit of $12,000. The employer can either make a matching contribution to the employee’s contribution up to 3 percent of the compensation or make a non-elective contribution, which is 2 percent of the compensation of the eligible employee. The non-elective contribution has to come through irrespective of whether the employee choose or not choose to contribute to his or her SIMPLE IRA.

An important point to remember about investing in a SIMPLE IRA is that withdrawals within 2 years of inception attract a penalty of 25 percent which is way higher than the usual 10 percent penalty for other retirement plans.