So, you’ve earned some extra cash? Isn’t it time that your cash works just as hard as you? Well, then there is no better time than now to start thinking about retirement contribution plans. Not only will you be investing in your future, but the IRS will even give you some perks.
Not all retirement contribution plans are equal so, before you jump in, you’ll want to explore all the options. You’ve likely heard of an IRA and a 401(k) but how do those compare to a SEP IRA and Solo 401(k)?
There are other retirement contribution plans out there but to keep this article from looking like a Harry Potter series, we’re focusing on our four favorite retirement plans for self-employed pros.
Even though we’re discussing your options below, we still highly recommend that you consult with your tax pro and financial advisor before deciding which retirement plan is best for you.
For the 2023 tax year, you’re eligible to contribute up to $6,500 ($7,500 if you’re age 50 or older) towards a traditional IRA. Contributing to a traditional IRA will lower your taxable income but it won’t help reduce your self-employment tax. What does that mean?
Let’s say that you’re single, earn $65,000 and take the standard deduction. You’re in the 22% Federal marginal tax rate, and you’ll reduce your tax liability by $0.22 for every dollar that you contribute towards a traditional IRA.
So, if you contribute the maximum of $6,000 then you’ll reduce your tax liability by $1,430!
If you live in a state that also allows you to deduct your traditional IRA contribution then you can factor your state’s marginal tax rate to determine your full tax savings.
In addition to reducing your tax liability, a traditional IRA is easy to set up and most brokerage firms don’t charge a fee to set up and maintain a traditional IRA.
You can also create and fund a traditional IRA up to the initial due date of your tax return (usually April 15) and have the contribution applied to the prior year. For example, if you make a contribution on April 10, 2024, then you can have the contribution deducted from your 2023 taxes.
Finally, just like all the retirement contribution plans that we’ll discuss, you get to determine which securities the plan acquires or you can have an investment advisor monitor your portfolio and tailor it to your needs.
Sign me up! Well not too fast. There are some disadvantages to a traditional IRA.
A traditional IRA has one of the lowest maximum contribution limits per tax year and can be limited or disallowed if your income is too high or if you or your spouse is covered by another retirement.
Plus, you only have until the initial due date of the tax return to make your contribution, unlike a SEP IRA and Solo 401(k), where you have until the final due date (including extensions) to make the contribution.
Lastly, your contribution is considered a tax deferral which means that you don’t pay ordinary income tax on the money you put in the traditional IRA. But Uncle Sam will come knocking when you retire and you’ll pay ordinary income tax on any distributions you take.
Traditional IRA Summary
Just like a traditional IRA, you can contribute up to $6,500 ($7,500 if you are age 50 or older) and you have until the initial due date to set up and fund the Roth IRA. You can also have a traditional IRA and a Roth IRA at the same time.
The major difference is that you don’t get a tax deduction when you contribute to a Roth IRA.
So, you may be asking, “Then what is the point?” Although there’s no immediate tax benefit to contributing towards a Roth IRA, your account has the potential to grow over time. And when you retire, you can withdraw the money tax-free.
Yes, you read that correctly, no matter how much your Roth IRA account grows, all your distributions will be tax-free when you retire.
This sounds too good to be true. Why doesn’t every one set up a Roth IRA?
Well just like the traditional IRA, you have to make sure you are under the modified adjusted gross income limits (see the MAGI limits for a Roth IRA contribution here).
Additionally, if you want to contribute to both a traditional IRA and a Roth IRA then your contributions are capped at $6,500 ($7,500 if you are age 50 or older) for all IRA accounts in a single year.
The truth is, a traditional IRA and Roth IRA are common retirement plans for taxpayers with W-2 income when their employer does not offer a retirement plan.
Roth IRA Summary
But what about solo-entrepreneurs? And what if you want to contribute more than just $6,000? Then you should look into creating a Simplified Employee Pension (or SEP) IRA plan.
Simplified Employee Pension (or SEP) IRA plans are a perfect fit for self-employed individuals that file a Schedule C along with their Form 1040 individual tax return.
Rather than limiting you to only $6,000 per tax year, a SEP IRA contribution limit is based on 20% of your net earnings from your self-employed activity, up to $66,000 for the 2023 tax year ($61,000 for 2022).
Let’s go back to the example we used for the traditional IRA. You’re single, taking the standard deduction, but this time your $65,000 in earned income is your net business income.
To calculate your SEP IRA contribution, we’ll subtract your self-employment tax deduction from your earned income.
Your maximum SEP IRA contribution is $12,082, which is 20% of your net earnings, $60,408.
That’s more than double the contribution of what was allowed under a traditional IRA or Roth IRA!
And with your marginal tax rate at 22%, that means you’ll reduce your federal tax liability by $2,658. If your state allows for the deduction then you would factor in your state’s tax marginal rate to determine your total tax savings.
You’re allowed to set up and contribute to your SEP IRA by the due date of your tax returns, including the extension deadline. This means that you’ll have until April 15, or if you file an extension, until October 15 to fund your SEP IRA and take the deduction towards the prior year tax liabilities.
Another benefit of a SEP IRA is that you’re not required to determine if your modified adjusted gross income is too high to make a contribution.
SEP IRA Summary
But what if you’re an S Corp?
The calculation to determine how much you can contribute is a bit different. You’re still eligible to contribute the maximum of $65,000 for the 2022 tax year ($58,000 for 2021) but instead of being capped at 20% of your net earnings, you’re capped at 25% of your compensation reported as wages.
Let’s say you have net business income of $65,000 and your S Corp employee wages were $36,000. The max you can contribute towards your SEP IRA is $9,000.
If you want to contribute more towards retirement then you’ll need to increase your reasonable compensation. But, that means that you have to pay more in payroll taxes.
SEP IRA Summary (S Corp owners)
So, is it a catch-22? Not exactly. What it means is that you’re a successful business owner and it’s time to consider setting up a Solo-401(k).
A Solo-401(k) allows you to wear multiple hats (and I am not talking about the ones with propellers)- one as an employee and the other as an employer. How does that work?
As an employee of your business, you can contribute up to $22,500 for the 2023 tax year ($20,500 for 2022). These contributions will need to go through your payroll and you can decide how much you want to contribute each year.
Unlike the other retirement plans we’ve discussed, the contribution deadline for your employee contributions is December 31, not when your taxes are due.
As an employer of your business, you can contribute up to 25% of your owner-employee wages (aka reasonable compensation). This portion of the contribution can be made by the due date of the tax return, including extensions.
That means you can fund the employer contribution by March 15 or, if you file an extension, September 15 and take the deduction for the prior year. So, what does that all mean?
If your net business income is $65,000 and your reasonable compensation is $36,000 then the combined maximum you can contribute is $31,500. Here’s how it breaks down:
- Employee contribution limit: $22,500
- Employer contribution limit: $9,000
Assuming that you’re still in the 22% marginal tax rate, you’d save $6,930 on your federal taxes. And that’s not even taking into account your state’s marginal tax rate to determine your total tax deferral.
Compared to a traditional IRA, you’d save more than $5,000 in taxes through a Solo-401(k).
The key difference between a Solo-401(k) and the other four retirement plans mentioned in this article is that a Solo-401(k) must be established in the year you wish to make a contribution.
Unlike the other plans, where you can set up the account by the filing deadline of a tax return, the Solo-401(k) must be established by December 31 of the tax year you want to take the deduction.
Solo 401(k) Summary
But whatever happened to not paying taxes when you retire?
Solo-401(k) are still a great option, especially because you can establish a Roth Solo-401(k) along with the Solo-401(k). Now you may be thinking, “But I already have a Roth IRA, why do I need a Roth Solo-401(k)?”
Unlike a Roth IRA, where the maximum you can contribute is $6,000 each year, you can contribute up to $22,500 for the 2022 tax year ($20,500 for 2022) with a Roth Solo-401(k).
Self Employed Retirement Plan Comparison
Never too early to think, plan, and consult
Am I safe to assume that you’ve heard of the saying “Less is more”? Well, the same concept applies to retirement contribution plans.
You don’t want multiple retirement accounts floating around by the time you retire. With more accounts, there’s more to keep track of and manage.
Luckily, the IRS allows you to consolidate your accounts. Instead of worrying about which retirement accounts you have laying around, you’ll spend your time worrying about where that waiter went with yourPina Colada while laying on the beach.
Retirement accounts that you consolidate are called rollovers and the IRS published a chart on which retirement accounts are eligible.
Determining the best retirement contribution plan is rarely straightforward and we recommend that you consult with your financial advisor and tax pro to help you decide which of these accounts are best for you.
Andrew is an EA and Director of Tax at Collective. After six years of service in public accounting, he’s thrilled to utilize technology to help freelancers succeed in their business.