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My inbox is full of investing questions from personal finance bloggers. I expected a few simple queries I could answer in a paragraph or two — I was wrong. The questions keep coming and they’re often complicated, so Thursdays will now be investing Q&A day.
One reader, Robert of The College Investor, asked: “What’s the best option for the self-employed — a SEP IRA or a Solo 401(k)? What are the pros and cons of each? Does the amount of income you make matter for your choice?”
A quick refresher: a SEP IRA is like a traditional IRA but allows much larger contributions for the self-employed, freelancers, and solopreneurs. An employer — even if you’re the only employee — can contribute up to 25 percent of an employee’s salary into a specially set-up traditional IRA for that employee’s future, with a maximum contribution of $51,000 in 2013. Contributions are discretionary, so you can contribute one year and skip the next.
A Solo 401(k) is designed for someone running their own business or a business with only immediate family members as employees. The contribution limits mirror a company-sponsored 401(k), but the owner can contribute both as the “employee” and the “employer,” which raises the total possible contribution. In 2014, you could defer up to $17,500 as an employee, plus a $5,500 catch-up if you’re over 50. The employer portion can add up to 25 percent of compensation. The maximum annual contribution was $51,000 in 2013 and $52,000 in 2014 (not counting catch-up contributions). For example, if you earn $200,000 a year and are older than 50, you could contribute $51,000 plus a $5,500 catch-up for a total of $56,500 to a Solo 401(k).
Using the same $200,000 example, a SEP IRA’s maximum contribution is $51,000, but the actual allowable amount can be lower after you account for the self-employment tax deduction and the contribution-rate formula. Vanguard’s calculator, for instance, estimates a $38,054.49 contribution in that scenario.
Which is best? It depends. If you don’t plan to borrow from your retirement account and your earnings aren’t high enough to make SEP’s lower effective limit a concern, a SEP IRA is probably the simplest choice. If you want the option to borrow from the plan and you need the ability to make larger contributions, a Solo 401(k) may be better — but expect more paperwork.
Does income matter? Yes. In most cases, a Solo 401(k) allows higher retirement-plan contributions.
Do you have a retirement account? What type did you choose and why?
