There is still time for sole proprietors to establish a retirement plan for 2023. And this year, some individuals may be able to contribute even more money, if they act before the tax filing deadline.
Sole proprietors can establish a plan using a SEP IRA or an Individual 401(k) and make a retirement contribution for last year. But they need to make the contribution before the tax filing deadline of April 15, 2024.
SEP IRAs have always had this flexibility. With the passage of SECURE 2.0, full retroactive contributions are now permitted for Individual 401(k) plans. There are two components to funding an Individual 401(k). Similar to a regular 401(k), savers can make elective salary deferrals as well as an employer profit sharing contribution. Prior to SECURE 2.0, sole proprietors were not able to contribute salary deferrals for the prior year. Now a full retirement contribution, including salary deferral as well as a profit-sharing contribution, can be made. As a result, a sole proprietor may be able to make larger (retroactive) contributions using an Individual 401(k).
The benefit of these retroactive contributions is that the sole proprietor may not be fully aware of their income and tax situation at the end of 2023. Now they can decide on an amount before the tax filing deadline in 2024, with an understanding of how much to contribute and what the impact would be on their 2023 tax bill.
Choosing the right plan
Comparing the options can help individuals choose the right plan for their financial situation.
The SEP-IRA and Individual 401(k) are the most popular options for sole proprietors funding retirement. Both are defined contribution plans and feature relatively high annual contribution limits. In addition, recent legislation allows SEP-IRA programs to offer Roth contributions like 401(k) plans.
Source: The figures in the table are for the 2023 tax year.
*SECURE 2.0 legislation allows a SEP-IRA to offer a Roth account option beginning in 2023. Note that as of this date, many providers are still updating systems and procedures to accommodate these recent changes, so the Roth account option may not be available yet depending on the custodian. Additionally, further guidance from the Treasury Department is needed to provide additional details on how Roth accounts would apply to a SEP-IRA.
Making the case for an Individual 401(k)
Because Individual 401(k) contributions technically consist of (employee) salary deferrals and an (employer) profit-sharing contribution, an individual may be able to contribute more to an Individual 401(k) than a SEP-IRA in certain cases.
For example, an individual with $100,000 in self-employment income is limited to a 20% contribution into a SEP-IRA. However, that same individual could contribute roughly double that amount using an Individual 401(k), consisting of a salary deferral (up to $22,500) as well as a 20% profit-sharing contribution. If that individual was age 50 or older, the Individual 401(k) would be even more compelling considering the maximum catch-up contribution of $7,500.
Example: 2023 maximum contribution for self-employed individual with $100,000 in net income
Source: Example based on net profit figure reported on Schedule C (Profit or Loss from a Business) or Schedule K-1 in the case of a partnership. Assumes the individual has not attained age 50.
One other potential benefit is the ability to do a “backdoor” Roth IRA contribution. This strategy may be used by those who cannot directly contribute to a Roth IRA because their income exceeds eligibility limits. For 2023, income phaseouts for Roth IRA contributions begin at $138,000 for single filers, and $218,000 for married couples filing a joint return. The backdoor strategy involves making a non-deductible (for example, after-tax) contribution within a traditional IRA and then subsequently converting that amount to a Roth IRA.
There are complications to this strategy, however, referred to as the “pro rata rule.” IRS rules mandate that when an IRA consists of after-tax and pretax funds, each dollar converted to a Roth IRA must include a pro rata portion of each. Converting only after-tax IRA funds to a Roth is not allowed. While funds held within a SEP-IRA are considered as part of the pro rata calculation for determining taxes on a Roth IRA conversion, funds held within an Individual 401(k) are not considered.
See more details about this strategy in our post, “Planning strategies to prepare if taxes move higher.”
Lastly, the loan option available with an Individual 401(k) provides another way to access funds in the plan.
The case for choosing a SEP-IRA
For those who are looking for a low-cost option that is relatively simple to establish, the SEP-IRA may be a better choice. The SEP-IRA also offers the flexibility to add employees without making changes to the plan. However, it’s important that plan contributions are based on a fixed percentage (up to 25% of compensation if there are employees) for all employees including the owner. Contributions may have to be made for part-time workers defined as those who have attained age 21, worked for at least 3 of the last 5 years, and earned at least $750 annually.
Self-employed individuals may want to seek professional financial advice before choosing a plan that is optimal for their financial situation.