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SMALL BUSINESS
JULY 1, 2019

I'm a sole proprietor. How can I save for retirement?

Answered by
Judith Anderson
Senior Vice President, Retirement & Personal Wealth Solutions at Bank of America
As a sole proprietor, you can generally choose between two kinds of tax-advantaged plans — the SEP IRA and the individual 401(k) — to save for retirement. If your goal is simplicity and ease of administration, the SEP (Simplified Employee Pension) may be the answer. Otherwise very similar to a Traditional IRA, the SEP offers two key differences: more generous limits on annual contributions and the fact that only employers, or sole proprietors, can make contributions under the plan. If you want to go a different route that offers additional flexibility and the ability to maximize contributions with pre-tax salary deferrals as well as the potential to borrow from the plan, an individual 401(k) could be better.
The chart below can help you compare at a glance the advantages — and limitations — of each.
Retirement plans at a glance: Individual 401(k) vs. SEP IRA
Individual 401(k) SEP IRA
Employer contributions are generally tax deductible by business Yes Yes
Plan expenses are generally tax deductible by business Yes Yes
Employer contributions are flexible Yes Yes
Business owners contribute as employees Yes No
Roth (after-tax salary deferrals) option Yes No
Plan loans available Yes No
Investment choices Menu of funds and model portfolios Broad range of investments
Additional IRS filing required Sometimes No
Annual dollar limits on contributions for participants under age 50 $56,000 for 2019 $56,000 for 2019; $55,000 for 2018
Annual dollar limits on contributions for participants age 50 or older $62,000 for 2019 $56,000 for 2019; $55,000 for 2018 (catch-up contributions are not permitted)

Here's a more detailed look at 3 key areas of difference:

"The SEP offers two key differences from a traditional IRA: more generous limits on annual contributions and the fact that only employers, or sole proprietors, can make contributions under the plan."
— Judith Anderson, Senior Vice President, Retirement & Personal Wealth Solutions at Bank of America

Contributions:

SEP IRA

Sole proprietors can normally sock away up to 20% of their net earnings from self-employment (as determined under the SEP IRA rules)Footnote 1 — generally, your business's net profit minus the deductible portion of your self-employment tax — up to a maximum of $56,000 for 2019 ($55,000 for 2018).
For example, if your net earnings from self-employment are $150,000, you can contribute up to $30,000 for 2018 as well as for 2019. See Deduction Worksheet for Self-Employed in IRS Publication 560, Retirement Plans for Small Business.

Individual 401(k)

As with a SEP IRA, you can make an employer's contribution, generally capped at 20% of your net earnings from self-employment. In addition, you can also make an employee's contribution of up to $19,000 for 2019, as well as $6,000 in catch-up contributions for individuals who are age 50 or older at any time during the year. The total combined contributions, not counting catch-up contributions, can't exceed $56,000 for 2019.
Thus, if your net earnings from self-employment in 2019 are $150,000 and you're under age 50, you can make a maximum employer contribution of $30,000 — plus an employee contribution of $19,000, or $49,0000 total.
To work out your contribution limit, use the Deduction Worksheet for Self-Employed in IRS publication 560: Retirement Plans for Small Business.

Tax treatment:

SEP IRA

Your contributions and plan expenses are generally tax-deductible. Distributions are taxed as income. Withdrawals before age 59½ are normally subject to an additional 10% federal tax.

Individual 401(k)

An individual 401(k) can be set up either as a traditional 401(k), with deductible contributions and taxable distributions, or as a Roth individual 401(k), with no deductions for employee salary deferral contributions but distributions that are normally federally tax-free during retirement, provided certain requirements are met. The SEP IRA doesn't offer that flexibility.

Set-up and administration:

SEP IRA

The deadline for creating a SEP IRA and for making contributions for a taxable year is your tax filing deadline, generally April 15 unless you file for an extension. You're responsible for administering the plan but won't have to file a report to the IRS.

Individual 401(k)

This plan must be established by the end of the last day of the tax year. Assuming there are no employees, the sole proprietor's contributions must be made by your tax filing deadline, including extensions. Once assets in an individual 401(k) plan reach $250,000, you must comply with the annual IRS Form 5500 filing requirements.
Help when you want it
Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
Footnote 1 The maximum compensation that can be taken into account for purposes of this calculation is $280,000 per participant in 2019 ($275,000 for 2018).

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