Should I contribute to a SEP IRA, a SIMPLE IRA, or a Solo-401K?
Being self-employed has some great benefits but one of the best is the retirement options. While most taxpayers only have the standard Traditional or Roth IRA options self-employed taxpayers have three additional ones. Simplified Employee Pension (SEP IRA), Savings Incentive Plan for Employees (SIMPLE IRA), and Individual 401(k) (Often called a Solo-401(k)).
Before going through the specific details of each plan there are a few things to mention. First, in general, these retirement plans function similarly to Traditional IRAs with a few differences. With Traditional IRAs, the contributions you make lower your taxable income and then grow tax deferred until you start making withdrawals. With the self-employed options they are deductions for normal income tax but they won’t help you save on self-employment tax. Next, for the most part, these options are good for self-employed individuals without any employee’s. Having employees can change the circumstances of your contribution limits and you should talk to an accountant before making any retirement planning decisions.
Self-Employed Pension (SEP IRA) work almost the exact same way as Traditional IRA’s with the only important difference being the limit you can contribute. That means you deduct contributions you make from your adjusted gross income. For 2023 the contribution limit is the lesser of 25% of your net earnings from self-employment or $66,000. The only trick is in calculating net earnings from self-employment. The calculation for computing net earnings from self-employment is as follows; Total revenue, minus total expenses, minus one half of your self-employment tax, minus the contributions you made to your SEP IRA. Looking at the formula initially is confusing because it includes a deduction for your contributions however it turns out the end result isn’t so tricky. It comes out to just 20% of your self-employment earnings.
Savings Incentive Plan for Employees (SIMPLE IRA), like the SEP IRA, work just like a Traditional IRA with the only important difference being the contribution limits. For SIMPLE IRA’s the limits for an employee are equal to 100% of your net earnings up to $15,500 or $18,500 if you’re over 50, plus an employer contribution of 3% of your net earnings from self-employment. For SIMPLE IRA purposes your net earnings from self-employment are your revenues minus your expenses multiplied by .9235. The .9235 accounts for your deductions for one half of your self-employment tax.
Finally an Individual 401(k), called a Solo-401(k), functions similarly to a 401(k) an employee would have with an employer. The difference being since you are self-employed you can make a contribution as the employee as well as the employer. The limits are an employee contribution equal to 100% of your net earnings from self-employment up to $22,500 or $30,000 if you are over 50, plus an employer contribution of 25% of your net earnings from self-employment. The employer contribution you can make is the same as the SEP IRA and it uses the same definition for net earnings from self-employment. Like the SEP IRA the total contribution amount (employee and employer combined) is $66,000.
If being self-employed wasn’t appealing enough these options certainly help.
Reading and understanding the contribution rules for these plans can be confusing, using them to your advantage will benefit you in the long run. Remember that these options are in addition to, not instead of, the normal Traditional and Roth IRAs that are available to everyone else. And while the above mentioned limits are good guide lines they are not all inclusive. Before making any decision about retirement that will impact your tax situation consult with an accountant to make sure you go over all of the specific rules that apply to your unique tax situation.