SEP-IRA versus Solo 401K

Solo 401K Plan Defined

A Solo 401K Plan can be defined as a plan of contribution offered by a corporation to its employees. The term 401K is derived from the IRS section describing the program. The Solo 401K Plan permits the employees to set aside tax-deferred income for retirement purposes. Solo 401K Plans are defined as savings plans in which employees are allowed to invest pre-tax income from their earnings and contribute that amount towards their retirement. And in some cases, employers will match their contribution dollar-for-dollar.

The solo 401k plan is suitable for businesses in which the owner or owners are the only employees. This plan works in a situation where there are "no common law employees, which means the plan can be used by the business owner, his or her spouse if working at the business, and any partners in the business and their spouses who work at the business. It could work well for businesses such as sole-practitioner professionals, partnerships, manufacturer's representatives, small retail owners, freelance writers, computer consultants, electricians, etc.

Why SEP-IRA is Sought-after?

SEP-IRAs are popular with self-employed people because they are simple and involve quick and less paperwork. Unlike Keogh plans, which have an annual reporting requirement, SEPs don't require annual reporting as long as each participant gets a copy of the plan agreement. The SEP is an IRA-based plan to which employers may make tax-deductible contributions on behalf of eligible employees. Each employee controls his or her own SEP-IRA account, and you send contributions to the bank, insurance company, or other financial institution where the employee's SEP-IRA is held. The employer is allowed a tax deduction for plan contributions, which are made to each eligible employees' SEP IRA on a discretionary basis.

Simple 401K Plan

Simple 401K Plan is another retirement plan sponsored by employers and avoids some of the fees to administration and paperwork plans such as 401K. Employers take advantage of the tax-deductible contribution made to the plan, and employees may elect to have salary deferrals in order to contribute to the plan.

On the other hand, a SEP-IRA can be defined as Simplified Employee Pension (SEP) that allows you to make contributions to an Individual Retirement Account (IRA) on behalf of yourself or your employees. It is a hassle-free retirement option for self-employed people or those with a few employees. In a SEP-IRA plan, contributions and the investment earnings can grow tax-deferred until withdrawal, which is assumed to be at retirement, at which time they are taxed as ordinary income.

SEP-IRA versus Solo 401K: A Comparison

SEP-IRA Solo 401K
Any sole proprietor, in a partnership, or a business owner can establish a SEP-IRA. Either an unincorporated or incorporated business, including Subchapter S corporations. The solo 401k plan is suitable for businesses in which the owner or owners are the only employees.
Any self-employed income earner (by providing a service), either full-time or part-time, even if you are already covered by a retirement plan at your full-time job can also establish a SEP-IRA. A Solo 401k plan may offer higher contribution limits than other retirement plans available for small businesses.
Plans generally funded by employee elective deferrals and employer contributions (such as SIMPLE-IRA and 401(k) Plans), employees have an opportunity to defer part of their salary to fund their retirement plans on a tax beneficial basis. In 2002, employer contributions to the plan did not exceed 25 percent of total payroll. Employee contributions are excluded from this limit. Previously, total plan contributions (both employer and employee) could not exceed 15 percent of total payroll of eligible employees.
Up to 25% of compensation, as much as $41,000 for the 2004 plan year and $42,000 for the 2005 plan year is allowed. Annual contributions are not required in the one-person 401k plan.
Any investment earnings grow tax-deferred until withdrawn. People with solo 401k plans may also take advantage of the new age-50 catch-up contributions, provided they qualify.
The maximum compensation on which contributions can be based is $205,000 for the 2004 plan year and $210,000 for the 2005 plan year. For self-employed individuals, compensation means earned income. The biggest benefit of this plan go to those who earn up to $160,000. This is because 25 percent of $160,000 is $40,000, the maximum limit. If you earn below $160,000 you can contribute 25 percent of your income as the employer, plus up to $11,000 (the maximum employee contribution) to get up to $40,000, rather than simply being limited to 25 percent of salary. A person 50 or older could contribute an additional $1,000 catch-up contribution, for a total of $41,000 in 2002.
Offering a retirement plan can make it easier to attract and retain valuable employees. Low paperwork requirements, including being exempt from discrimination testing as long as you have no eligible employees. The only annual paperwork you may be required to file is the IRS Form 5500, which applies when plan assets exceed $100,000. The IRS provides a form 5500EZ that is suited to small 401k plans.
The ability to take a loan. SEP plans and SIMPLE IRAs, popular retirement plans with small businesses, don't allow loans, although a profit-sharing plan could. Setting up a one-person 401k entails more responsibility than a SEP or SIMPLE IRA.
Contribution percentage can vary each year, from 0% - 25% of compensation, up to $41,000 per participant for the 2004 plan year and $42,000 for the 2005 plan year, whichever applicable. For one thing, the plan needs a trustee to hold the assets on your behalf. Many people act as their own trustee, but if you decide to do this you need to be very attentive to details specified by the plan.
All SEP-IRA contributions must be made by the employer, and the same percentage of compensation must be contributed for each eligible employee (based on W-2 wages) including the employer. Best retirement plan for owner-only businesses.

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