1) The Solo 401k has some big advantages that the SEP-IRA doesn’t have.
2) The retirement plan you choose will have an impact on the QBI (Qualified Business Income) and the amount of total income tax you pay. Work with the right professionals on this. Consult your financial advisor and CPA.
3) Proactive financial planning done throughout the year can help you maximize your opportunities to reduce your taxable income and increase your ability to save for retirement.
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[5:52] – Jack and Jason compare the SEP-IRA and the Solo 401k.
- A Solo 401k allows profit-sharing. You can put 25% of your wages into profit-sharing and the cap on contributions is $57k.
- The SEP-IRA also allows profit-sharing.
- The profit-sharing contribution is technically made by the company.
- For employee deferrals for 2020, it’s $19,500 + $6500 catch up using a Solo 401k.
- The SEP-IRA has no employee deferrals.
- The absolute maximum that can go into a SEP-IRA is $57,000 or 25% of your wages.
- The Solo 401k actually allows a bit more money on a pre-tax basis.
- Profit-sharing is on the employer side. If you’re doing it for yourself, you’re also doing it for the other employees that qualify under that plan.
- A Solo 401k is still a 401k plan, but it’s specifically a 401k plan for an employer that really doesn’t have any employees.
[11:24] – Jason and Jack discuss aspects of the Roth 401k vs. the SEP-IRA.
- On the Roth 401k you have the ability to defer money into the Roth portion.
- On the SEP-IRA that doesn’t even exist. There’s the pre-tax portion and the traditional portion, there is no Roth.
- You can take a loan out on your 401k up to 50% of the value with a $50,000 cap. With a SEP-IRA that doesn’t exist.
[12:42] – Jack and Jason discuss when a mega backdoor Roth can be implemented.
- The SEP-IRA does not allow after-tax deferrals that convert to Roth.
- Some 401k plans will allow for after-tax contributions. This is often offered by larger companies.
- It is possible to do a mega backdoor Roth on a Solo 401k.
- A mega backdoor Roth is a huge opportunity for proactive tax planning.
[14:36] – Jack and Jason discuss when in the tax year you can set up these different accounts.
- For the tax year 2019, you can still set up a SEP-IRA and make the contribution for the prior year (2019). You can’t do that for the Solo 401k.
- Solo 401ks need to be established by December 31st of the year where contributions will go in.
- The SEP-IRA can be established in the following year up until your tax-filing deadline plus extensions and you can still make a contribution for the prior tax year.
- The profit-sharing portion for 2019 can be added until the final tax deadline.
- The door is closed for W-2 deferrals or employee deferrals.
[16:20] – Learn which accounts are eligible for backdoor Roth funding.
- If you want to do a backdoor Roth, that option is still available if you have a Solo 401k or a 401k and no other IRA balances. The minute you open a SEP-IRA and contribute, you can no longer utilize that strategy.
- The IRS requires taxpayers to aggregate the value of all IRA accounts so you wouldn’t be able to selectively convert the after-tax contribution.
- LHWM often sees the SEP-IRA in situations where a single person owns a business and there are no employees.
- The Solo 401k has some big advantages that the SEP-IRA doesn’t have.
[19:57] – Hear a case study that illustrates the comparisons between these accounts.
- The clients were a husband and wife that both own a service business with no employees and they’re both over fifty. Total income is $450k year filing as an S corporation. They each pay themselves $100k, leaving profits in the company of $250k.
- You can do just about everything in a 401k that you can do with a SEP-IRA and with more flexibility.
- When they came to LHWM, this couple had a SEP-IRA account set up for their company that they were max funding. $25,000 was going into those accounts for each person.
- The client’s goal was to reduce taxes, accumulate assets, and save for their financial independence.
- They were considering increasing their W-2 wage, allowing them to put more in SEP. However, that would increase payroll taxes.
- They’re in the 35% marginal tax bracket.
- The retirement plan you choose will have an impact on the QBI and the amount of total income tax you pay.
- LHWM proposed doing a Solo 401k.
[27:21] – What did the solo 401k do for this client?
- It helped them maximize both of their goals.
- By having a Solo 401k, they are still able to do that 25% profit sharing contribution. Their salaries did not change. They can defer either pre-tax or Roth. LHWM advised pre-tax deferrals based on their current tax bracket. They deferred an additional $19,500 plus $6500 catch up from the salary portion of their income.
- The QBI for both scenarios as modeled by a CPA was exactly the same. The deduction was $40k for both.
- They received the deduction for profit-sharing but they also were able to do $52k in employee deferrals. At a 35% tax bracket, that’s roughly an $18k tax reduction.
- There are many moving parts with the QBI deduction.
- The right mix of salary vs. leaving profits in the company and the specific impacts depend on individual scenarios.
- They were able to reduce their taxable income by $52k and that is a good thing now and also in the future.
- They qualified for $40k in QBI, reduced their taxable income, and saved more for retirement.
- By rolling their SEP-IRA into a Solo 401k, they now had a zero balance in IRAs. They were able to do $7k each in the traditional IRA and then immediately convert it into Roth IRA. Every year they now have an additional $14k that’s going to grow and accumulate. Those earnings will be tax-free in retirement.
- They received immediate tax benefits and from a proactive planning standpoint, they’ve got a bucket they didn’t have before.
- You need to do a lot of planning early and throughout the year. You can’t wait until the end of the year to do this.
- Work with the right professionals on this.
- It does make a difference if you are an S Corp or a C Corp. There are different forms and different causes and effects. It’s not one-size-fits-all.
- The business owner has lots of opportunities that the employee doesn’t. But with those opportunities come complexities.
- There are many opportunities for those that plan.
- Reach out if you have questions. Email Jason at firstname.lastname@example.org, Jack at email@example.com, or contact us at profitstowealth.com/contact.