Taxes for the Self-Employed can be Steep!
In addition to regular income tax rates business owners are responsible for an additional “self-employment” tax.
Consider that if you are married and earn $200k in 2021, your income puts you in the 24% federal tax bracket. Add self-employment taxes and you’re looking at almost 40% of your income paid in taxes – before considering state taxes. If you live in one of the US states with rates 9%+ you are likely paying almost half of your hard-earned money to the government in the form of income taxes.
But did you know there is a way to defer taxes on up to $58,000 of your income as a self-employed person or small business owner?
There are actually two popular options: the Simplified Employee Pension Individual Retirement Account (SEP IRA) and the One Participant 401(k) plan (Solo 401k).
Read on for information about each option.
What’s up with this “self-employment tax” situation?
The so-called self-employment tax is actually just your contributions to Social Security (12.4%) and Medicare (2.9%). This is always paid whether you work for someone else or for yourself. But when you work for someone else your employer pays a large part of that tax for you. Since self-employed people are “their own business” they have to cover both the employee and employer parts of these taxes.
What is a SEP IRA?
A SEP IRA functions essentially like a regular IRA. You open an account type of SEP IRA, make your allowed contributions, and decide how to allocate the funds.
The easy part is opening and funding the account; picking the appropriate investment portfolio for your needs is more complex of a decision. If you aren’t comfortable weighing the various factors and managing the account yourself you might want to speak with a fee-only financial advisor about how they can help.
What is a Solo-401k?
A Solo 401k is, quite literally, a traditional 401k plan but that only covers a business owner without any employees.
Historically Solo 401k plans have been expensive and a record-keeping burden. This isn’t just a Solo 401k “concern” – 401k plans, in general, have these challenges (speaking as a previous business owner that provided one).
BUT, competition and rule changes over time have made this a much more affordable option. Currently, a number of the big brokerage companies and most financial advisors can help you get your Solo 401k opened. And the costs are often now inline with SEP IRA costs – if there are any administrative costs at all!
Contributions to a SEP IRA
If you are self-employed, or a small business owner with less than 100 employees, you are likely eligible to make contributions to a SEP IRA.
If you work for someone else, THEY would need to establish the SEP IRA and make contributions for you. That would be an uncommon arrangement – for the reasons mentioned below.
Contributions to a Solo 401k
If you are a business owner with NO EMPLOYEES, you are likely eligible to open a Solo 401k account. Having even a single employee, beyond you and your spouse, would eliminate this option for you.
How Much Can You Contribute to a SEP IRA?
Per IRS rules, you can contribute the lesser of $58,000 or 25% of your income to a SEP IRA plan.
How you reach the maximum contribution (for 2021) of $58k is a common point of confusion for business owners.
To be able to contribute the maximum you need eligible earned income of around $300,000.
Because the contributions are deductible from your income.
If you make $300,000 you deduct the $58,000 from your income – giving you a taxable income of $242,000. Taking 25% of the $242k puts you just above the $58k contribution amount.
Note that this is a simplified example to show the general use and power of this planning practice. There are factors, such as whether you are a sole proprietor or incorporated (and how), that can impact the calculations. Please work with a professional fee-only financial planner or tax advisor, like a CPA, for help understanding your specific situation.
How Much Can You Contribute to a Solo 401k?
A very interesting difference between the SEP IRA and Solo 401k is that the Solo 401k allows you to defer up to $19,500 (in 2021) regardless of the income earned. If you are age 50 or older you can contribute an additional $6,500 as a “catch up” contribution.
After you’ve hit the $19,500 limit you can still make additional contributions – up to 25% of your salary or earnings.
Note that the total amount of the contributions for a Solo 401k has the same $58,000 annual limit as the SEP IRA. So if your earnings are high enough you might not notice a difference between the SEP and the Solo 401k. But in certain situations, especially with lower earnings, a Solo 401k will allow business owners to contribute more than a SEP might.
When Does it Make Sense to Contribute to a SEP IRA?
Deciding whether to contribute to a SEP vs a Solo is largely dependent on whether or not you have employees in your business. The IRS doesn’t allow Solo 401k contributions if you have employees, so that’s the first consideration. If you have employees, cross the Solo 401k off the options list.
If you make less than $30,000 per year in your business, you likely won’t be able to contribute more to a SEP IRA than you would a standard IRA. But once you start earning more, the ability to save on current year taxes justifies more consideration.
Does it Make Sense to Contribute to a Solo 401k?
If you don’t have any employees, a Solo 401k is definitely worth considering.
As mentioned above, in some situations you can contribute more to a Solo 401k than you would be able to with a SEP IRA – especially on the lower range of owner salaries.
What is Your Tax Rate?
But consider this: If you are married filing jointly in 2020, and have a household taxable income of $81,050, your federal income tax bracket is just 12%.
You’ll need to consider whether income tax rates might be higher, lower, or the same in the future.
Remember, with retirement accounts (IRA, SEP IRA, 401k, Solo 401k, etc) you aren’t avoiding the need to pay taxes on that income. What you are doing is deferring the need to pay taxes on that income. Money put into a retirement account today is taxed when it is withdrawn in the future.
If you believe that the tax rate you’ll pay today is lower than it might be during your retirement – perhaps you should just pay the taxes now and put your savings into a standard brokerage account.
On the other hand, if you believe your tax rate will be lower in the future, deferring taxes from the current year to be paid in the future might make sense for you.
A Decent-Sized SEP IRA “Catch”
One big point to understand about SEP IRAs: The IRS has built-in a rule to make sure employers don’t benefit from this option disproportionately to their employees.
So if you have employees you pay, you’ll need to contribute the same percentage for them as you do yourself.
To max out the benefit for yourself you might want to make the maximum 25% contribution. Just remember that it will increase your total payroll costs by 25% since each employee will get the same benefit level.
Getting Started with Your SEP IRA or Solo 401k
With research and a little effort, you can educate yourself on SEP IRA and Solo 401k options to determine which retirement plan makes the most sense for you.
If you are a DIY investor you can then open an account with a brokerage like Fidelity, TD Ameritrade, or similar. They’ll explain which paperwork to complete and how to get the account both opened and funded. Then you just need to decide how best to invest then execute the steps for your retirement investing plan.
But, if you are like many business owners who prefer to focus on running and growing their business, letting professionals help in other areas that make sense, you might want to engage with a fee-only fiduciary financial advisor to talk about your retirement planning needs.