We work with a lot of sole proprietors, and one conversation that we routinely have with these entrepreneurs is answering the question:

“What is best for me when it comes to saving for retirement?”

As sole proprietors, these business owners are often in an enviable position as they can best take advantage of the power of these retirement plans.

For certain profession types with high and consistent income, we continue to believe that a defined benefit plan, potentially combined with a 401(k) plan, is a fantastic option for sole proprietors to consider. However, one scenario we often see is a sole proprietor deciding between a SEP-IRA (“SEPs”) and a one-person 401(k), more commonly known as Solo 401(k). SEPs have long been a commonly used option for to reduce taxes and save for retirement because the contribution limits are higher than traditional IRAs. However, there are several compelling reasons to opt for the Solo 401(k) plan instead.

The key differences between the SEP and the Solo 401(k) stem from their contribution amounts and sources. 

SEP vs. Solo 401(k)

In an SEP…

SEP holders are restricted to contributing 25% of earned income. Meanwhile, 401(k) plans allow for the sole proprietor to defer up to $23,000 ($30,500 if age 50+), in addition to receiving a contribution from the “employer” (the Sole Proprietorship) up to a maximum of $69,000 ($76,500 if age 50+). As a result, the entrepreneur must have a much higher level of net profit to reach the same contribution amount in a SEP vs. a Solo 401(k).

As an example, let’s say we have a Schedule C Sole Proprietor who is below age 50 and has net profit of $100,000. For Sole Proprietors with Schedule C income, the calculation can be a little complex to arrive at the amount of retirement contribution available. As we show below, the maximum amount that this sole proprietor can contribute in a SEP is $18,587.

In a Solo 401(k)…

Conversely, in a Solo 401(k), the sole proprietor can make this same $18,587K contribution in addition to the $23,000 as an elective employee deferral. In short, the 401(k) allows this person to contribute $41,587 in total vs $18,587 for the SEP at the same net profit level of $100,000.

Winner: 401(k)!

Mega-backdoor Roth Conversions

One other plan feature that we are frequently asked about are mega-backdoor Roth conversions. Although they are a topic for their own blog post, mega-backdoor Roth conversions can be fantastic in situations where there are no other employees that would present problems with non-discrimination testing. For this specific blog post, Solo 401(k)s have a compelling advantage over SEPs as the pro rata aggregation rules are applied separately to each 401(k) account. This means that if the Sole Proprietor is doing the conversion within the 401(k) plan, all after-tax dollars can be transferred to a Roth 401(k) sub account or Roth IRA while ignoring the other IRA accounts in the process. With SEPs, the account balance is aggregated with other IRAs that the Sole Proprietor may have. This is potentially a big deal because if the Sole Proprietor has existing IRAs with pre-tax dollars in them, it means that there will be a tax liability when doing the conversion. The Sole Proprietor side steps this issue with a Solo 401(k).

Additional Timing Flexibility on Elective Employee Deferrals

Lastly, Section 317 of SECURE 2.0 has allowed additional timing flexibility on making the elective employee deferrals after a calendar year is over when establishing the plan. Previously, elective deferrals had to be made prior to the calendar year end. With the rule change, the Sole Proprietor can now make elective deferrals up to their tax filing date (note, however, the language for this section states that the date is “without regard to any extensions”). As an example, a Sole Proprietor can establish a 401(k) plan in February 2024 and still defer the maximum amount as well as receive the employer contribution for their 2023 tax return if they have not already filed their taxes.

Work with a TPA

Not to complicate things any further… but, with new rules around Long Term Part Time Employees (LTPTE), it has never been more important to work with a retirement plan third party administrator (like the Pension Source) on your Solo 401(k) vs. going it alone.

In Conclusion…

In conclusion, Sole Proprietors have several great options to choose from. We’d love to have a discussion with you about tailoring a tax-advantaged retirement plan to your liking. Our passion is improving retirement outcomes for small business owners and their employees. Reach out if you’d like to learn more at sales@thepensionsource.com.