Tax season is with us, and tax planning is likely top of mind! One of the few methods for deferring tax is the use of retirement accounts such as IRAs, SEP IRAs, and 401(k)s.
Traditional and Roth IRAs
The SECURE Act removed the 70 ½ age-limit restriction that previously applied to traditional IRA contributions. As a result, anyone with earned income (income subject to payroll taxes) may contribute to a traditional IRA. The deductibility of your traditional IRA contribution still depends on your modified adjusted gross income and whether you are covered by an employer retirement plan.
The traditional IRA or Roth IRA* contribution limits for 2021 and 2022 are $6,000 ($7,000 if over 50), and the contribution deadline is April 15th.
*Your ability to contribute to a Roth IRA depends on your modified adjusted gross income (irs.gov).
SEP IRAs and Solo 401(k)s
You have more options to save for retirement when you have self-employment income. The SEP IRA and Solo 401(k) are the first options to explore. As the name suggests, Solo 401(k)s are available to people with self-employment income but no employees, while SEP IRA plans allow for the addition of employees once they become eligible to participate.
Assuming an owner has no employees, the contribution limits can be the deciding factor as to which plan to establish. The SEP IRA contribution is $58,000 for 2021 ($61,000 for 2022), but your personal contribution limit is derived from your net business income and could be much lower.
The maximum Solo 401(k) contribution is $64,500 for 2021 due to the $6,500 “catch-up” contribution permitted those who have reached the age of 50. Because the SEP IRA contribution is composed only of employer contributions, the plan does not need to be established or funded until the tax filing due date (including extensions). While Solo 401(k)s have the same deadline for establishment, generally both the salary deferral ($19,500 in 2021) and catch-up portions must be contributed before 12/31;only the profit-sharing portion may be contributed after year-end, unless an exception applies.
Assuming your personal contribution limits are equal, the 401(k) could be the better choice if you would like the option to borrow from the plan or make after-tax (Roth) salary deferrals, as these actions are not permitted by SEP IRAs.
Q: May I contribute to the 401(k) with my employer and a Solo 401(k)?
A: Yes, but the cumulative contributions are aggregated. For example, Susan has a 401(k) through her employer but has self-employment income from selling handmade crafts online. The maximum cumulative salary deferral (employee contribution) is $19,500 (2021). As such, if she has deferred $19,500 of her salary to her employer’s plan, she cannot mirror the salary deferrals to her Solo 401(k); however, she can still make a profit-sharing contribution to her Solo 401(k) plan.
Q: May I contribute to the 401(k) with my employer and a SEP IRA?
A: Yes. Similar to the example above, Susan would also have the option to contribute to a SEP IRA instead of a Solo 401(k).
Q: If I’m still working at age 72, are there required annual distributions from my SEP IRA or Solo 401(k)?
A: Yes. While you will still be able to contribute to these plans while you are working, you will be forced to take distributions after you turn 72.
Q: If I am maxing-out contributions to my retirement accounts, what other options do I have for deferring income?
A: A defined benefit plan may be appropriate if you are self-employed and your business income is high, stable, and relatively predictable. For employees, a deferred compensation plan (if offered by your employer) would allow for additional retirement savings
Please review your unique tax situation with a professional before significantly altering your retirement savings tax strategy, and please contact us with any retirement planning questions.