Solo 401k vs. SEP: Contribution Limits
With tax rates increasing, self-employed and small business owners are thinking of ways to shelter more income. This leads many to consider the SEP IRA and the Solo 401k retirement plans because of their high contribution limits.
Choosing the Solo 401k vs. SEP
The SEP IRA and Solo 401k are both well-known for their high contribution limits. In 2013, the maximum contribution limit for both plans is $51,000. When comparing Solo 401k vs. SEP however, the Solo 401k plan has the clear advantage. The Solo 401k Plan allows greater potential to reach the maximum limit because of the way it calculates contributions to the account.
Calculating the Contributions
Both the Solo 401k and the SEP IRA allow an employer contribution of up to 25% of the compensation, or net self-employment income.
With a SEP IRA, the $51,000 maximum contribution limit can only be achieved in this employer capacity. The total contribution is calculated as a percentage of the net income. In order to reach the maximum $51,000 contribution with a SEP IRA, the total net income from self-employment in 2013 must be at least $255,000.
Since contributions to the SEP IRA are based on percentage of net income, the maximum limit can only be achieved if the net income is high. If the net income is lower, the contribution amount will be significantly lower than the maximum, because the contribution is based on a percentage, not a dollar amount.
The Solo 401k Plan allows contributions to be made in two capacities, giving greater potential to meet the $51,000 limit. The plan allows contributions to be made as both employer and employee.
In addition to the employer capacity, a Solo 401k contribution can also be made in the capacity of an employee. This employee salary deferral can equal up to $17,500 in 2013.
Those age 50 and above are also eligible for an additional catch-up provision of $5,500, in effect raising the maximum Solo 401k contribution limit to $56,500 for those age 50 and above. The SEP IRA does not have this provision.
The Solo 401k Rules allows contributions to be calculated as both employer and employee. The SEP IRA calculates contributions only in an employer capacity.
The high contribution limit is not enough to determine which plan is best. When choosing between Solo 401k vs. SEP, remember that the Solo 401k gives greater potential to reach its high contribution limit.