Self-Directed Retirement Options: SEP IRA v. Solo 401k

When you work for a corporation, your retirement fund normally consists of a 401(k) plan administered by a third party provider. But what happens if you’re self-employed? A …

When you work for a corporation, your retirement fund normally consists of a 401(k) plan administered by a third party provider. But what happens if you’re self-employed? A standard IRA is always an option, but it won’t give you the benefits of a corporate 401(k). In order to attain some of those benefits, self-employed individuals have traditionally opened a SEP IRA. The SEP IRA allows for contribution levels similar to those of a 401(k), but without the excessive paperwork that often accompanies a retirement plan. Recently, though, another option has been gaining traction: the self-directed Solo 401(k). This is an IRS approved Qualified Retirement Plan that is tailor made for self-employed workers. At first glance, the two platforms – the SEP IRA and Solo 401(k) – appear very similar, but on a closer look, the Solo 401(k) actually has a number of distinct advantages.

1. Roth Component

A Solo 401(k) can be set up as a Roth; a SEP IRA only allows for Traditional contributions.

2. Custodian Fees

A SEP IRA, like every other IRA, is mandated by law to be held by a third-party custodian. This typically involves annual management fees and transactions fees. A self-directed Solo 401(k) does not need a custodian. Rather, the Solo comes in the form of a Trust of which the investor is appointed as the sole Trustee. The investor can then open a checking account in the name of the Trust at the bank of his/her choosing, and use that checking account as the investing vehicle. This effectively gets rid of all the typical custodian fees.

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3. Personal Loan

One of the golden rules in retirement plans is that of Prohibited Transactions. In short, an investor may not receive any personal benefit from his/her retirement plan until retirement age. A personal loan is considered a Prohibited Transaction, and thus is not allowed in a SEP IRA. In the Solo 401(k), however, a personal loan of up to $50,000 is permitted.

4. Real Estate Advantage

If an investor uses retirement funds to purchase real estate, then there is a potential tax liability called UDFI – Unrelated Debt Financed Income. This applies when the investor purchases the property using a loan or a mortgage in conjunction with the retirement funds. The portion of the profits that can be attributed to the leveraged amount is taxable. Like most other retirement plans, the SEP IRA is subject to UDFI. The Solo 401(k), though, is not subject to UDFI. This means that even those profits attributed to leverage will receive the tax deferred benefits of standard retirement funds.

5. Prohibited Transactions

When a SEP IRA engages in a Prohibited Transaction, the consequences are severe. There is a 10% penalty, as well as a distribution of the account itself. This means that the SEP IRA structure is dissolved, and any applicable taxes are due immediately. With a Solo 401(k), a Prohibited Transaction incurs the 10% penalty, but the plan itself remains intact. As long as the offending transaction is reversed, the plan can continue running as usual.

6. Maximize Contributions

The maximum annual contribution to both plans is $50,000. In the SEP, a worker may contribute (depending on how he/she files) up to 25% of net income. The Solo’s contribution schedule works more like that of a standard 401(k): there is a Profit Sharing contribution and a Salary Deferral contribution. The Salary Deferral contribution can be 100% of income, up to $17,000. This allows the investor to more easily reach the $50,000 limit.

You already know how to fly solo with your business. Now your retirement plan can reap Solo benefits as well.


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