Which Self-Employed Retirement Account Is Right For You? Choosing Between A SIMPLE IRA vs SEP IRA vs Solo 401(k)

For the self-employed, saving for retirement can be a headache. Just choosing the right account can be tough. Learn about the three main retirement accounts for the self employed and which fits your situation.

Retirement savings can be complicated at the best of times, but self-employed people have it especially tough. Unlike most workers who get access to retirement accounts from their employer, the self-employed have to do it all on their own.

There are three main types of retirement account that the self-employed can use, the SIMPLE IRA, the Self Employed (SEP) IRA, and the Solo 401(k). Each has its own benefits and drawbacks.

Basics of Retirement Accounts for the Self-Employed

Retirement accounts for the self-employed share one unique feature that is not found in other retirement accounts. Because you work for yourself, you are both the employee and the employer in your business. That means that you’re able to make contributions to retirement account as both an employee and an employer.

If you’re familiar with standard 401(k) plans, you’ll know that the annual contribution for employees limit is $18,000, but that employers can make additional contributions on top of that. Because you’re both the employee and employer, you have the potential contribute more to your retirement account than most people.

Contributions to retirement accounts are tax deductible. That means that you can deduct your employee contributions from your income when you file your taxes at the end of the year. You can also deduct your employer contributions from your business taxes.

Even if you can’t max out your contributions as an employee, making employer contributions is a good idea because of the additional taxes businesses pay.

SEP IRAs and SIMPLE IRAs can be set up for a self-employed person or small business. Solo 401(k)s, also known as self-employed 401(k)s are only for people who work for themselves and who have no employees.

SEP IRA

SEP IRAs do not share many qualities with the IRAs that most people are familiar with. The biggest difference is that most companies that offer SEP IRAs will only allow employer contributions to the account. The lack of employee contributions for Self Employed IRAs vs 401(k)s’ $18,000 limit is their biggest weakness.

SEP IRAs have a very large employer contribution limit: $54,000 per year. The catch is that you may only contribute up to 25% of the employee’s compensation, (20% if you are contributing for yourself). That means you’d need to make $270,000 in a year to reach the contribution limit for your own account.

You can decide how much to contribute each year or to contribute nothing at all. That makes SEP IRAs great for small businesses that don’t want to commit to contributing each year.

SEP IRAs are perfect for people who have a day job but do some freelance work on the side. They offer plenty of flexibility and your access to a 401(k) from your day job means you won’t miss the ability to make employee contributions.

There is very little paperwork required to open a SEP IRA vs a Solo 401(k), so they’re also good for self-employed people who don’t want to deal with the annual upkeep of the plan.

SIMPLE IRA

When comparing a SEP vs SIMPLE IRA, you’ll find that there is relatively little similarity between them. The SIMPLE IRA is, as the name implies, designed to be the easiest plan to open and run. Its rules are straightforward and it provides a moderate amount of tax-advantaged space that you can use.

Any self-employed person or small business with 100 or fewer employees can start a SIMPLE IRA plan for their business.

SIMPLE IRAs work very similarly to standard 401(k) plans. Employees can choose to contribute to the plan or choose not to. Those that do contribute can only contribute up to $12,500 to the SIMPLE IRA, vs. 401(k)s’ $18,000 limit.

One thing to note is that if you also have access to a 401(k) through another job, you cannot contribute $12,500 to your SIMPLE IRA and $18,000 to the 401(k). You may only contribute a maximum of $18,000 split across the two plans.

The employer is obligated to contribute to each employee’s SIMPLE IRA each year. The contribution can come in the form of matching of employee contributions or as a flat 2% of each employee’s compensation.

When the contribution comes as a match, it cannot exceed $12,500. When it comes as a flat amount, it can’t be more than $5,400. That makes the upper limit on contributions just $25,000, much less than the $54,000 limit on Solo 401(k)s and SEP IRAs.

If you are running a small business, a SIMPLE IRA will give you the most tax-advantaged savings space at the cost of required contributions to all of your employees’ accounts.

Solo 401(k)

The Solo 401(k) is the most similar to the 401(k) offered by employers across the United States.

As the name implies, small business owners that have employees cannot open Solo 401(k)s. Only people who work for themselves can open a Solo 401(k).

Like a regular employer’s 401(k), you can contribute up to $18,000 each year as an employee. You can also make matching contributions as your own employer. You can contribute up to 20% of your compensation as the employer, up to a total contribution limit of $54,000.

To max out contributions to a Solo 401(k), you need to make $180,000, which is less than the amount you’d need to make to max out a SEP IRA.

Solo 401(k)s require more paperwork than other types of retirement plans for the self-employed. They also share contribution limits with any other 401(k) plan you may have access to. That means they often aren’t worth the trouble if you have a day job that also offers a 401(k).

Opening a self-employment retirement account is a great way to take control over your retirement. Many employer-offered plans have poor investment choices and expensive management fees.

As your own employer, you can choose whatever investments you’d like, letting you avoid unneeded expense. You can use Personal Capital’s retirement fee analyzer to find the best deal and make sure your money keeps working for you.

 

Photo credit: InvestmentZen Images

TJ Porter

TJ Porter has been sharing his financial expertise through his writing since 2014. He graduated with a degree in business from Northeastern University in 2016. In his spare time, TJ enjoys esports, cooking, and board games.

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