The SEP-IRA and Solo 401(k): Your Secret Sauce for Building Wealth

As professional independent consultants,  if we want the benefits that an employer might provide – medical and dental insurance, retirement, and personal time off – we have to provide them for ourselves. 

If you worked as an employee in the past, a 401(k) plan may have been one of your benefits. 401(k) plans allow you to save money for retirement and defer paying the taxes until you make a withdrawal, presumably once you are retired. 401(k) plans have several potential benefits: 

  • Lowering your current tax bill because you don't pay taxes on the money you put into the 401(k).
  • The ability to save a bit more since you're paying less in tax.
  • You are likely to pay less tax on that money since your tax bracket in retirement is likely to be lower than it is now.
  • Some employers match some portion of your contribution, or make profit-sharing contributions.

Many staffing firms and compliance providers offer their own version of the 401(k). These firms and their corporate partners may even cite them as an advantage to giving up your independent status and signing on for their W-2 payroll. 

Taking the W-2 payroll path will cost you money! 

First, retirement plans offered through staffing agencies are often not as robust as the plans top corporations create for their employees, plans that may offer profit-sharing, match employee contributions, or even help you manage your investments. More significantly, as independent contractors, we have access to better retirement planning vehicles that can reduce our tax bill by thousands per year. 

These options are the Simplified Employee Pension (SEP-IRA) and the Individual 401(k), sometimes called a Solo 401(k). Like a company 401(k) plan, the SEP-IRA and Solo 401(k) lower your net income for the current tax year (often significantly), and let you earn decades of compound growth without current taxation. (See the related story, “1099 vs W-2 ” for an example.) However, unlike a company 401(k), the retirement plans available to the self-employed have higher contribution limits and a wider range of investment options. Additionally, the SEP-IRA offers a lot more choices if you want to take more control of your investments, and the Solo 401(k) opens up the possibility to set aside even more money than the $54,000 allowed by the SEP IRA.

Figuring out the best option can be complicated. You can get a rough idea of your options by running various scenarios through tax preparation software, but it’s best to consult your tax advisor about your specific situation. Here is a short summary of the differences between the plans (or download a PDF here).

The bottom line: If you are self-employed, a SEP-IRA or Solo 401(k) is a much better alternative than a traditional 401(k) through a staffing firm. Also, in most situations you can contribute more to an individual 401(k) than you could contribute to a SEP-IRA, although actually having that much money to contribute can be a challenge.  

When you went from corporate employment to self-employment, you probably faced sticker shock the first time you paid self-employment taxes. So it may be tempting at first to let a staffing firm pick up that employer portion of taxes. Using the self-employed retirement plans, SEP or Solo 401(k), can more than compensate for that cost. Enrolling in one of them might just be your secret sauce for creating wealth.

To compare maximum deduction amounts on an individual 401(k), SEP IRA, or Simple IRA plans and which plan would provide the best benefit to you, we suggest using the self-employed calculator at Bankrate.com

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