By Michael Vaughn, CFP®
As a dedicated professional, finding time to save for retirement can be challenging with so many other priorities vying for your attention. Balancing daily family responsibilities and managing business operations often means that retirement planning gets pushed to the bottom of your to-do list.
Even when you make the effort to start a retirement plan, navigating the vast amount of information and determining what’s best for your situation can be overwhelming. But it doesn’t have to be this way. There are various retirement plan options available for self-employed professionals, such as individual 401(k) accounts and SEP IRAs. Here’s how to choose the option that suits you best.
Individual 401(k)
Also known as a solo 401(k), an individual 401(k) is designed for business forms with only one employee, the business owner. The IRS calls it a one-participant 401(k) and only businesses without employees are eligible.
Key Benefits
- Roth accounts: As with other 401(k) plans, the individual 401(k) offers both traditional and Roth accounts. With a traditional account, contributions are made pre-tax and taxes are paid upon withdrawal. Roth 401(k)s, on the other hand, are funded with after-tax dollars, but they grow tax-free. This gives you the flexibility to actively choose the contribution style that works best for your specific tax situation.
- Employee deferrals: Individual 401(k) plans also allow employee deferrals in addition to the employer contribution. This option is not available with SEP IRAs.
- Loan provisions: Another benefit of this plan is the ability to take loans against the account balance up to the lesser of 50% of the balance or $50,000.
- Higher contribution limits: Individual 401(k) plans have two types of contribution limits. First is the profit-sharing limit for employer contributions, which is the lesser of 25% of business revenue or $69,000. The next limit is the annual employee elective deferral limit, which is $23,000 for individuals with an additional $7,500 for those over age 50. The combined limit for both employer and employee contributions is $69,000 (or $76,500 if older than 50), but because there are two types of contributions permitted, most self-employed individuals will be able to contribute more and receive a larger tax break than if they used a SEP IRA.
Drawbacks
- Strict reporting requirements: If your account balance exceeds $250,000, you will be required to file an annual return with the IRS. The return consists of Form 5500 and it can be quite extensive. Even if you don’t have $250,000 in your account, you may be required to file.
- Only available for businesses with no employees: Individual 401(k)s are only available for businesses with no employees except the owner’s spouse. If you have plans to expand your business and hire additional employees, opening an individual 401(k) is probably not for you. You may be required to convert your plan to a qualified 401(k) and contribute on behalf of your employees if you were to hire any.
SEP IRA
A Simplified Employee Pension (SEP) IRA functions similarly to a traditional IRA, except as the owner, you set up and contribute to accounts for both yourself and your employees.
Key Benefits
- Tax-deductible contributions: Your contributions are tax-deductible up to 25% of all participants’ compensation, or up to 25% of net earnings if you’re self-employed.
- Higher contribution limit: In 2024, the contribution limit for a SEP IRA is the lesser of 25% of an employee’s compensation or $69,000. This limit is higher than the limit for tax-advantaged accounts like traditional and Roth IRAs, but as mentioned above, it’s not as high as the limits for individual 401(k) plans.
- Easy setup & maintenance: SEP IRAs do not require the extensive reporting requirements required by other qualified retirement plans. You are also not responsible for the underlying investments in your employees’ accounts. As the employer, you simply choose the financial institution you want to work with and you open the accounts. Beyond that, it is the employees’ responsibility to choose and manage their own investments. Additionally, many financial institutions offer SEP plans with little to no management fees, making this a very inexpensive and attractive option for small business owners.
- Contributions are discretionary: Contributions to these plans are flexible and discretionary, meaning you can adjust your contributions as your cash flow changes. This ensures you’re never contributing more than you’re bringing in.
Drawbacks
- Strict eligibility requirements: According to the IRS, all employees must be allowed to participate in the SEP plan if they are age 21 or older, earned at least $750 in 2023, and worked for you for at least 3 of the last 5 years. This can make SEP IRAs an inflexible option for small businesses that want to limit the number of employees in the plan.
- When you do contribute, you must contribute to everyone: In the years that you contribute to a SEP IRA, you are required to make equal contributions as a percentage of compensation to all eligible employees. For instance, if you contribute 20% of your income to your own SEP IRA, you must then contribute 20% of every employee’s income to their respective accounts. Because of this, SEP IRAs are generally recommended for self-employed individuals or small businesses with very few employees.
- No loan provisions, Roth accounts, catch-up contributions, or employee deferrals: Many of the benefits offered by individual 401(k)s are not available for SEP IRAs.
Make the Right Decision for You
If you’re a self-employed individual or owner of a small business, don’t put off saving for retirement. At Pinnacle Family Advisors, we can help you pick the retirement plan that best aligns with your goals and aspirations.
Book a chat with no strings attached, and let’s see if we’re the team you can count on for a comfortable retirement. Reach out to us and schedule your complimentary introductory meeting by emailing me at [email protected], calling (417) 351-2942, or using my online calendar.
About Michael
Michael Vaughn is a CERTIFIED FINANCIAL PLANNER™ professional and Vice President at Pinnacle Family Advisors (PFA) with 24 years of industry experience. Before joining the PFA family, he served clients with investment management and retirement planning at The Mutual Fund Store for 14 years. Michael graduated from Missouri State University with a bachelor’s degree in business administration and management and earned his CFP® certification in 2004. He also served 20 years in the Missouri National Guard, retiring in 2007 as a Major. He currently volunteers on the board of directors for Good Dads and Fellowship of Christian Athletes. Michael is married to Lori and they have two daughters. To learn more about Michael, connect with him on LinkedIn.