7 Ways to Rank Retirement Plan Options for Independent Contractors and the Self-Employed (Updated Nov. 2023)
Topics: Solo 401K, SEP, Simple IRA, Contribution Limits, Checkbook Control, Tax Savings
I’ve talked about Retirement Plans before, most recently a couple months ago when I wrote Why Should Independent Contractors Use a Solo 401K for Asset Management? However, while I still feel the Solo represents the best option, I wanted to further illustrate that point, plus outline strengths and weaknesses among the Solo 401K, SEP and Simple IRA for those that have a choice, such as Independent Contractors and the Self-Employed. Admittedly, this will be a lot to digest, but I believe it’s a good resource to help make a decision on what Plan is best for your Individual Business.
For clarification, the Solo 401K is like the traditional 401K but for individuals and it adds an employer contribution component. The SEP (simplified employee pension) is a similar savings vehicle for the self-employed but only allows employer contributions. Lastly, the Simple IRA (Individual Retirement Account) is an IRA account that allows for greater contributions than a traditional IRA.
So, I’ll go through 7 different Ranking Factors for each of the three primary investment vehicles available for the do-it-yourself group. You can look at the list of 7 items, determine which is most important to you, and then base your decision on which plan performs best under that framework.
The Seven Ranking Factors
- Contribution limits
- Tax Savings
- How contributions are made
- Administrative costs and setup
- Flexibility – Roth Account, Checkbook Control, Borrowing, Catchup, Spousal Contributions
- Benefit to employers
- Early Withdrawal
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On a personal note
I’ve mentioned before my preference for the Solo 401K. I chose it because I want to maximize my savings over the long-term (up to $66,000 in pre-tax savings in 2023!), while reducing my tax burden (taxable income is reduced by the same amount). Plus, I can reap the benefits as I’m starting up my business – even if I don’t make much money, as long as I make at least $22,500 in income, I can still make the same personal contribution (of $22,500) allowed to anyone in 2023 with a 401K Plan. The additional flexibility of a Roth option, catch up contributions, and checkbook control make it even sweeter. Lastly, my plan is to grow this business as much as possible without hiring full-time help (in this case using virtual assistants, independent contractors or an employee that works less than 750 hours a year – or about 15 hours/week). That means I need to focus on the things I do well and enjoy (meeting with people, creating Financial Plans, Money Management) and outsource the rest (compliance, marketing, IT, administrative tasks ) I haven’t yet gotten to that point, but I’m trying to automate more (processes/logistics, scheduling, tasks, communications, marketing), which will ultimately allow me to better serve client needs as well. I expect the Solo will be functional during my career as an Advisor based on my current goals.
Onto the 7 Ranking Factors
- Solo 401K
- Simple IRA
Analysis: The Solo wins out due to the potential for catchup contributions. The Solo and SEP both offer $66,000 in pre-tax contributions for 2023, but the Solo has an additional $7,500 savings option this year for those at least 50 years old – so $73,500 in total. The Simple just can’t keep up with a $15,500 contribution limit for 2023 plus a $3,500 catchup – or $19,000. Even despite the potential for an employer match (a 3% dollar-for-dollar match or flat 2% regardless of employee contribution), the Simple still lags.
- Solo 401K
- Simple IRA
Analysis: The Solo wins again for the same reasons above and the fact that any contributions from these plans directly reduce taxable income, assuming you are an Independent Contractor or Single-Person Business Owner with control of both your personal and corporate contributions (you make a contribution personally and the company you control makes contributions for you). Your tax savings would then approximate the amount of contributions multiplied by your tax rate ($66,000 x 24% tax bracket = $15,840 reduction in your tax bill).
How contributions are made
- Solo 401K
- Simple IRA
Analysis: The Solo leads again because of the control of contributions an employee has, or the employee elective deferrals (the $22,500 personal contribution) that can be made during the same calendar year (2023 contributions can happen in 2023) as long as the employee has made that much in income. Similar for the Simple but it gets 2nd due to its smaller $15,500 contribution limit. The employer contribution, which is the entire $66,000 for the SEP (maxed out at 25% of employee compensation), the balance for the Solo to get to $66,000 (or $43,500) and the 2-3% match for the Simple would most likely be made the following year (2023 contributions in 2024) after a CPA has reviewed your company’s tax situation but before taxes are actually filed. So the ability to start contributing more than a year before and letting the Time Value of Money commence earlier is enough reason to use a Solo in my opinion.
Administrative costs and setup
- Simple IRA and SEP (tie)
3. Solo 401K
Analysis: Setup is pretty straightforward in terms of opening these types of accounts. I do this for clients whose money I manage. Behind the scenes, however, both the Simple and SEP have required IRS forms (to be filled out, not filed) and the 401K would have a (potentially elaborate) set of plan documents depending on what features were included. These documents would be provided by a custodian or third party (for a cost of several hundred dollars or more), but any cost would be to maximize the flexibility (see below) of the particular Plan. Additionally, the Solo has ongoing administrative requirements with specific tax filings required for Plan assets in excess of $250,000, which likely require an annual fee, albeit fairly small (a fraction of the setup fee) in my experience.
Flexibility – Roth Account, Checkbook Control, Borrowing, Catchup, Spousal Contributions
- Solo 401K
- Simple IRA
Analysis: The Solo outpaces the Simple because you can design a Plan (as alluded to above) that offers Roth contributions (pay taxes initially and gains grow tax-free!) and “checkbook control” (you can buy assets personally for your 401K with some limitations). Similarly, you can borrow the lesser of 50% of assets or $50,000 from a Solo (though the CARES Act bumped this up to $100,000). The Simple is slightly better than the SEP, but really only because it allows for a catchup opportunity (for 50 years old or older). I’ll also include Spousal contributions here because a spouse can largely enjoy the same benefits with their own Solo plan. A great example is a spouse doing administrative, part-time work earning $22,500, which could be entirely contributed into a Solo account. A Simple could only provide the $15,500 contribution max while a SEP could only provide up to 25% of employee compensation.
Benefit to Employers
- Solo and Simple IRA (tie)
Analysis: While we are generally talking about single-person businesses, it’s worth noting that as a business owner you may also be an employer. A simple IRA provides the simplest way to help out an employee without using your own resources in excess. The 401K has a more convoluted math equation to provide a company match dependent on ages and incomes of all employees. Plus, if you have a non-spouse employee working more than 750 hours a year, you are no longer eligible for a Solo Plan and would need to use a standard 401K. However, the Solo and Simple flip-flop in terms of vesting, as the Simple is an IRA and therefore any contribution to the account would immediately become the employee’s, whereas the 401K plan may have a vesting schedule. The SEP is similar to the Simple here (funds into a SEP immediately become the employee’s) plus the SEP lags big-time as it requires the same % contribution for every employee. Therefore, maximizing your own benefit could require a hefty contribution to employees.
- Solo and SEP (tie)
3. Simple IRA
Analysis: The rules are largely the same across the board in terms of withdrawals. Distributions are taxed at ordinary income tax rates (unless you have a Solo 401K with a Roth component) after age 59 ½. Any withdrawals prior to that would be taxed similarly but would also have 10% penalty. In the event that funds from a Simple are taken out early and within two years of plan participation, there is a 25% penalty – yikes!
So in closing, this analysis shows the Solo 401K is the best overall Retirement Plan option for Independent Contractors and the Self-Employed. Where it lags on cost and administration would only be due to added (albeit minimal) expense and effort to take full advantage of its significant flexibility (Roth option, Checkbook Control, Borrowing, Spousal Contributions). While this is a reiteration of the factors I find important lining up with the Solo being the best product for me, hopefully it’s also a useful analysis to determine what’s most important for you, as an Independent Contractor or Self-Employed business owner. I would love to walk you through the set up and management of any of these types of accounts for you, your employees and your household!
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Best wishes on your financial path!
This post was created by Matt Beeby, the Founder of MHB Advisory Services. Matt has been working in Financial Services and investing in real estate since 2005, though his investment experience spans nearly two decades. He is a Christ follower, active in both his church and his neighborhood association. Matt enjoys sports and family time. Read more about Matt on his website bio.
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