Quitting one’s day job and launching into the unknown is an exciting yet stressful rite of passage for many entrepreneurs. Building a business is hands-on; pitching, getting funding, and generating profits all fall onto your shoulders. Most entrepreneurs are too swamped by their daily tasks to worry about their own finances. Retirement, the distant and abstract future, is especially at the bottom of their “to-worry” list.
However, it’s important to remember that time is capital. For retirement savings, time is an extremely powerful ingredient to generate impressive growths. The longer you invest, the more your money can snowball over time. As an army of one, you would be happy to know that there are retirement plans for entrepreneurs designed specifically to meet your needs. These plans can offer you great tax-benefits. Additionally, they are easy to set up and maintain, perfect for your busy schedule.
Important concepts to know
An entrepreneur is considered as both the employer and the employee in a retirement plan. Wearing two hats means that you can contribute to a retirement plan twice. Here are some important terms that you need to have in your pocket.
Most restrictive requirement
Each retirement plan has a set of eligibility requirements. While an employer is allowed to lower the requirement to cover more employees, they are not allowed to make it more limiting than the most restrictive requirement set out by the IRS. This helps prevent unfair exclusion and protects the employees.
Nondiscrimination testing
The nondiscrimination testing is required by the IRS for qualified plans – plans with tax advantages. It makes sure that the tax benefits provided are proportional and fair to all employees regardless of their pays. Some retirement plans are subject to such testing.
Catch-up contributions
Contribution to retirement plans is limited to a certain amount each year. The contribution limit varies by the plan. However, in some plans, the limits are raised for people over a certain age to help them save more for the approaching retirement.
Matching contributions
Some plans allow employers to match employee contributions, generally dollar-for-dollar. For each dollar the employee contributes, the employer will match with another dollar up to the contribution limit. As an entrepreneur, you can use matching contributions to increase your savings because you can make contributions as both the employee and the employer.
Pre-tax and Roth
Contributions can be categorized based on their tax status. Pre-tax contributions are made with income before paying taxes. They reduce your taxable income and subsequently your tax obligations. Roth contributions are made with post-tax dollars. However, Roth accounts allow the individual to withdraw from the accounts tax-free once they meet the distribution requirement.
Now we have gone through some important concepts for retirement plans, let’s go through your options as an entrepreneur.
Option one: solo 401k
As its name suggests, a solo 401k is designed for a solo entrepreneur and their spouse. This plan is easy to maintain but comes with all the benefits of a regular 401k. You can think of it as a VIP 401k plan made just for you.
Eligibility
Any self-employed business owner can qualify for this plan as long as the business has no other full-time employee. Additionally, you don’t have to work full-time to join this plan. For example, you could have a full-time job but have a freelancing practice on the side. For freelance work, you are able to set up a solo 401k.
There is no most restrictive requirement because the plan is only designed to cover the business owner and their spouse.
Contribution
Because of your dual role as both the employer and employee, you can make two contributions. First, the employee (which is you) can contribute to this plan through salary deferral. Additionally, the employer (also you) contributes to the solo 401k through profit sharing. The total contribution is limited to $57,000 in 2020.
Contribution part one – employee salary deferral contribution
As an employee, you can make contributions to your solo 401k. The contributions reduce the total allowance for all your 401k accounts. If you are employed by another firm with a 401k plan, both accounts will share the same contribution limit. Your contributions can be either pre-tax or Roth, which gives you more flexibility for tax planning.
Your contribution to the solo 401k as the employee is limited based on the table below. If you are 50 or older, the limit is raised by $6,000 to allow for catch-up contributions.
| Regular Contribution | Catch-up Contribution (50 or older) | |
| 2018 | $18,500 | $24,500 |
| 2019 | $19,000 | $25,000 |
| 2020 | $19,500 | $26,000 |
(source: IRS)
Contribution part two – employer profit-sharing contribution
As the employer, you can make a second profit-sharing contribution. The contribution limit is 25% of the employee’s taxable compensation. When you are self-employed, the calculation can be a little bit more complicated. You can use this formula to calculate your profit sharing contribution limit.
Based on this formula, the maximum contribution self-employed employers can make is 20% of their taxable income. If you are using a lower contribution percentage, we recommend you to speak with an accountant to ensure you are contributing the right amount.
Setup and maintenance
Setting up a solo 401k is pretty straightforward. You can work with a brokerage firm to set up an account and most companies provide a plan document (a prototype) you can use to establish your plan. Because there is no other employee, there is no testing requirement for a solo 401k.
Option two: SEP IRA
A SEP IRA (Simplified Employer Pension Individual Saving Arrangement) is an IRA account that the employer can contribute to on behalf of the employee. The SEP IRA plan is available to all small businesses with fewer than 100 employees. The main benefit of this plan is that it is easy to set up and manage. There is no filing requirement for the employer, which eliminates start-up and operating costs of maintaining a retirement plan. In comparison to a solo 401k, employer contribution is mandatory. Employees can make contributions up to the total limit for IRA type accounts.
The reason this account is mostly used by sole proprietors and self-employed entrepreneurs is that under this plan the employers must contribute for all eligible employees. This could be a burden if you have other employees.
Contribution limit
Contributions to SEP IRAs mainly come from the employer. While employees are allowed to contribute, their contributions will reduce the contribution limit of other IRA accounts such as a traditional or Roth IRA.
The contribution limit for a SEP IRA applies to all eligible employees in your firm including you, the business owner. The amount is determined by the lesser of:
- 25% of compensation
- $57,000
The employer must contribute the same percentage to each employee’s SEP IRA. For example, if you contributed 25% of your own compensation to your SEP IRA, you must then do the same for every eligible employee.
Because of this contribution rule, SEP IRA is mostly used by sole business owners.
Most restrictive requirement
While employers are allowed to make the eligibility threshold lower to cover more employees, they cannot make it more restrictive. Based on the guideline from IRS, the most restrictive requirement for SEP IRAs is the following:
- At least 21 years old
- Worked for your business three out of the past five years
- Received or will receive $600 in compensation for the current year
Setup and maintenance
SEP IRAs are easy to set up. First, you choose a trusted financial institution such as a bank or a brokerage firm as the trustee of the SEP IRA plan. The employer must execute an agreement with the trustee, outlining information related to participation requirement and more. Then, the employer must share the plan information with all employees before opening the IRA accounts.
Compare your options – Solo 401k V.S. SEP IRA
Both solo 401k and SEP IRA are great retirement plans. In general, a solo 401k offers more flexibility and a higher contribution limit that can benefit many entrepreneurs.
Contribution limit
Both solo 401k and SEP IRA share the same contribution limit of $57,000. However, the solo 401k plan allows more actual contribution if your total earning is below $224k. For example, if an entrepreneur’s income is $150k. Under SEP IRA, they can contribute 25% of their total income, which is $37.5k. Under a solo 401k, they first contribute $19k through employee contributions. Then as an employer, they can contribute another $30k (20%). This boosts the total contribution to $49k under a solo 401k.
Flexibility
Solo 401ks also offer more flexibility when it comes to catch-up contributions and loans. While SEP IRA doesn’t allow for catchup contributions, solo 401k allows for a $6,000 additional contribution if you are 50 or older. Solo 401ks also provide loans against your retirement plan which IRAs don’t allow.
Investment options
In general, investment options under a solo 401k plan are limited to mutual funds. While mutual funds are convenient and require less active management, they also restrict your investment strategies. A SEP IRA, on the other hand, allows you to invest in almost any investment product including stocks, bonds, mutual funds, and ETFs.
Comparison table
We know that comparing these two plans can be overwhelming. To help you choose the best retirement plan, we outlined the main differences between a solo 401k and a SEP IRA in the table below.
| Solo 401K | SEP IRA | |
| Contribution Limit | Employee – $19,500 Employer – 25% of taxable compensation (20% for sole proprietors and LLC owners) Max. contribution $57,000 | The lesser of 25% of compensation or; $57,000 |
| Contribution Type | Employer – pre-tax Employee – pre-tax or Roth | Pre-tax |
| Loan | Allows loans up to the lesser of 50% of the 401k portfolio or; $50,000 | Loans are not allowed |
| Catch-up Contribution | $6,000 additional contribution | Not allowed |
| Filing Requirement | Form 5500 EZ for solo 401ks worth more than $250k | No filing requirement for the employer |
Conclusion
Setting up a retirement plan is often not a priority for entrepreneurs and it is understandably so. However, some plans are very easy to set up and can offer you great tax advantages in the long run. We hope this article illuminates the options available and can help you boost your retirement savings in 2020!
