Working with busy professionals, especially real estate agents and high-income earners, means helping them pursue quick growth on a tax-efficient basis. When designing wealth strategies so my high-income earning clients can live out their idea of a rich, rewarding life, the conversation first turns to choosing the right retirement plan for them. Real estate agents and self-employed individuals typically want to know which is better, the SEP IRA or a solo 401(k). In this blog post, I’ll help clarify which is best dependent upon a few factors.  I’ll also explain how to maximize your retirement savings and avoid paying a large amount of your income to the tax man. 

Choosing the right retirement savings plan: SEP IRA VS. Solo 401(k)

As a successful real estate agent or high-income earner, you understand that importance of finding tax benefits where you can get them. That’s exactly what retirement plans can do. They not only help you have automated savings for when employment income ceases at retirement, but it also serves as a reduction to current taxable income that would otherwise have gone to Uncle Sam. That being said, I’m often asked by clients about which type of retirement plan is best for them.

For the self-employed, the two types of retirement plans that work best are the SEP IRA and the Solo 401(k).  Both plans are similar, but with some key differences. Although each have a laundry list of fine print in the IRS coding, I will boil it down to what features are the most prevalent to the self-employed high-income earner.

Simplified Employee Pension Plan or SEP IRA

A SEP IRA can be a good option for the self-employed, especially if you have a few employees on the payroll. The premise is pretty simple. A SEP IRA allows you to put money into the account on a tax deductible basis and have the money grow tax-free until you turn the age of 72 and the IRS mandates that a portion be withdrawn and taxed annually over your mortality table rate.

What makes the SEP IRA more attractive than others starts with the larger contribution limits. In 2020, you can contribute the lesser of:

·      25% of compensation (Limited to maximum of $285,000 of compensation for the calculation)

·      Or $57,000

The calculation to come up with your compensation, for contribution purposes, can be complicated. It is advised that you seek a good CPA to help in this calculation. Otherwise, here is a brief excerpt from the IRS website:

Plan compensation for a self-employed individual

To calculate your plan compensation, you reduce your net earnings from self-employment by:

• the deductible portion of your SE tax from your Form 1040 return, page 1, and

• the amount of your own (not your employees’) retirement plan contribution from your Form 1040 return, page 1, on the line for self-employed SEP, SIMPLE, and qualified plans.

You use your plan compensation to calculate the amount of your own contribution/deduction. Note that your plan compensation and the amount of your own plan contribution/deduction depend on each other – to compute one, you need the other (this is a circular calculation). One way to do this is to use a reduced plan contribution rate. You can use the Table and Worksheets for the Self-Employed (Publication 560) to find the reduced plan contribution rate to calculate the plan contribution and deduction for yourself.

In addition, if you contribute to yourself AND you have employees, then you must also contribute to their SEP IRA plans. This means that if you contribute 25% of compensation to yourself, then you must also contribute 25% of employee compensation to their plans.

If you have had long-term employees that work very hard to contribute to your success, then this is a great way to reward them.

If, however, you are like most of the real estate agents I work with, then turnover is just a part of the business. In that case, there is good news. The IRS has very friendly language for what makes an employee eligible for a contribution:

·      The employee must be 21 years or older

·      They’ve been employee with you for 3 of the last 5 years

·      The employee earned at least $600 with employment directly for you over the last year

Another consideration is the lack of additional “catch-up” contribution for those agents who are 50 years or older. This additional funding can add up if you plan to have a long career.

Bottom Line:

The SEP IRA can be a powerful retirement savings tool in terms of both high contribution limits, tax-free potential growth, and tax deductibility for both your plan and the deductibility of contributions to employee plans.

Sole-Participant 401(k) or Solo 401(k)

A solo 401(k) operates similarly to a traditional corporate 401(k) plan. Also, similar to the SEP IRA, the solo 401(k) allows you to contribute to the plan on a tax deductible basis, and have tax-free status on the potential growth inside of the retirement account.

To make it simple, when it comes to the solo 401(k), the self-employed wears two hats: the employee and the employer.

As an employee, the plan allows you to contribute up to the 2020 annual contribution limit of $19,500. If you are age 50 or older, you are allowed to make an additional contribution of $6,500 to make it $26,000 in total.

As an employer, you are also allowed to contribute to the plan up to 25% of compensation as defined by the following: 

When figuring the contribution, compensation is your “earned income,” which is defined as net earnings from self-employment after deducting both:

• one-half of your self-employment tax, and

• contributions for yourself.

The total contribution for 2020 to a Solo 401(k) is $57,000. An additional contribution allowance for those 50 and older of $6,500, which then brings the total contribution to $63,500.

In order to set up a solo 401(k), there are some additional steps. You would need to obtain an employer identification number or EIN and contact a provider to set up the plan. In addition, it would require you to fill out a plan adoption agreement and file an annual report on Form 5500-SF if it has $250,000 or more in assets at the end of the year.

Although it’s not that complex, there is a bit more responsibility that goes along with it.

Bottom Line

The solo 401(k) allows the ability to contribute a large chunk of money annually for those real estate agents with high income earnings from their business. In addition, you cannot contribute to a solo 401(k) if you have employees other than your spouse. This can make the choice very easy if don’t plan to bring on W-2 employees.

There is also more to think about in terms of requirements and responsibilities, albeit not too burdensome.

Either the SEP or the solo 401(k) can offer massive benefits for real estate agents or high-income self-employed individuals. When taxes can weigh you down your ability to maximize savings, consider one of these retirement options. The answer may just boil down to whether you currently have employees or plan to have employees.

If you have questions specific to your situation, don’t hesitate to call for a complimentary consultation.