tax tip for self-employed

Last Minute Tax Tip for the Self-Employed

If you, like many, have earned some income from self-employment during the pandemic, you may have already set up an Individual 401K to shelter some of that income from your 2020 tax bill.  Establishing and funding an Individual 401(k), also known as a Solo 401(k), may be one of the best ways to both cut your tax bill and rapidly build your retirement nest egg.

But what if you missed the December 31, 2020 deadline to set up your Individual 401(k)?  In this case, you actually still have an option.  Because the deadline to set up and fund a SEP-IRA is later than for an Individual 401(k), you can still shelter some of your 2020 income between now and your tax filing deadline by establishing and funding a SEP-IRA.  You will most likely not be able to contribute as much to a SEP-IRA as an Individual 401(k), but some tax savings is better than no tax savings.  In our view, this short window of time is the only time that the SEP-IRA offers an advantage over the Individual 401(k). 

First, what is an Individual 401(k) and is it better than a SEP-IRA?


An Individual 401(k):

  • Must be established by December 31 of the year you want to contribute (funding can come later)
  • Allows you to contribute 25% of profits (wages), with a 2020 contribution limit of $57,000. This includes a $19,500 “salary deferral” contribution.
  • Plan owners over 50 may also make an additional $6,500 “catch-up” contribution for a total of $63,500
  • Click here for more information about 401(k)s.

 The relative advantage of an Individual 401(k) over a SEP-IRA, however, is most stark for individuals at lower income levels. Let’s look at an example under both plans:

  • Someone earning $50,000 of income from self-employment could contribute $12,500 to a SEP, saving roughly $3,125 in taxes (@ a 25% assumed rate).
  • This same person, however, would be able to contribute $32,000 to an Individual 401(k). $12,500 plus $19,500 of salary deferral, saving roughly $8,000 in taxes (@ a 25% assumed rate).
  • Thus, at lower levels of self-employment income, the Individual 401(k) offers much better tax-savings potential.

Because you can usually make a larger contribution to an Individual 401(k) than to a SEP-IRA, the Individual 401(k) is usually a superior choice for self-employed individuals with no employees. Higher contributions mean more tax savings and faster growth of your retirement account.

So, if you missed the December 31 401(k) deadline, what can you do?

If you would be better off using an Individual 401(k) to build your retirement nest egg but missed the December 31 deadline to establish one, you can take two steps:

  1. Establish a SEP-IRA before your 2020 tax filing deadline and make the maximum allowable SEP contribution for 2020.
  2. Then, in 2021, establish an Individual 401(k) and roll the assets from the SEP into the new 401(k) and use the 401(k) as your retirement plan going forward.

Please contact us if you would like to us to offer our views on how, for your particular circumstances, you can best cut your tax bill while saving for retirement.

If you earn over $100,000 in self-employment income, read more about what we consider the most powerful retirement plan, called a defined benefit plan.  

Visit us at: Defined Benefit Plan Solutions

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Peter Thoms, CFA, MBA

Peter Thoms, CFA, MBA

Peter Thoms, CFA, founded Orion Capital Management LLC in April 2002. Peter has extensive experience managing investment portfolios for clients pursuing a wide range of financial goals.

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