We recently received the following client question (paraphrased): I currently have self-employment income from a consulting job and would like to save some of it in a retirement plan. What is the best employer retirement account to open in order to save some of this income in a tax-advantageous way?

The main retirement account options for self-employed individuals are Savings Incentive Match Plans for Employees (SIMPLE) IRAs, Simplified Employee Pension (SEP) IRAs, and individual 401(k)s which are also called i401(k)s or solo 401(k)s.

We have excluded SIMPLE IRAs from the table below. SIMPLE IRAs are the easiest to establish but have the smallest contribution limits of the employer sponsored retirement accounts. Most business owners benefit from having a larger contribution limit than SIMPLE IRAs offer.

Here are some of the pros and cons of specific SEP IRA and individual 401(k) retirement account options available:

	Tax Year 2023 Contribution Limit	Pros	Cons
SEP IRA	Employer: the smaller of $66,000 or 25% of compensation Employee: $0 After-Tax Employee: $0	– Free to set up – Eligible for immediate rollover to an IRA and eligible for immediate conversion to Roth – Can be custodied at Schwab	– Interferes with backdoor Roth if it has a balance on December 31 – No Roth contributions – No employee contributions allowed – No nondeductible after-tax employee contributions (Mega-Backdoor) allowed
Roth SEP IRA	Employer: the smaller of $66,000 or 25% of compensation Employee: $0 After-Tax Employee: $0	– Doesn’t interfere with backdoor Roth	– Not available at any custodian yet
i401(k) at Charles Schwab	Employer: the smaller of $66,000 minus employee contributions or 25% of compensation Employee: $22,500 After-Tax Employee: N/A	– Free to set up – Doesn’t interfere with backdoor Roth regardless of balance – Permits employee contributions / can have a higher contribution limit – Custodied at Schwab	– Does not permit Roth contributions – Does not permit nondeductible after-tax employee contributions (Mega-Backdoor) – Does not permit in-service rollovers of employee contributions to an IRA before age 59 1/2 or retirement – Does not permit in-plan Roth conversions
i401(k) at MySolo401k	Employer: the smaller of $66,000 minus employee contributions or 25% of compensation Employee: $22,500 After-Tax Employee: the smaller of 100% compensation or $66,000 minus total of all other contribution types	– Doesn’t interfere with backdoor Roth regardless of balance – Permits employee contributions / can have a higher contribution limit – Permits Roth contributions – Permits in-plan Roth conversions – Permits nondeductible after-tax employee contributions (Mega-Backdoor) – Custodied at Schwab but Schwab is not the record keeper	– Has a set up fee + an annual admin fee – Does not permit in-service rollovers of most account balances to an IRA before age 59 1/2 or retirement

 

One of the main benefits of opening an i401(k) is that it allows employee and employer contributions whereas SEP IRAs only allow employer contributions.

Additionally, i401(k) balances do not count towards your total IRA balance used to calculate the taxable amount of your backdoor Roth contribution each year.

For these reasons, many self-employed individuals would likely benefit from opening an i401(k) either through Schwab’s or MySolo401k’s i401(k) offering.

MySolo401k may enable individuals to save more money and place more of it as Roth from the beginning, but it comes with an additional cost.

Determining if it is worth the additional cost would depend primarily on these two questions:

1. Does the amount you plan on contributing fit within the Schwab i401(k) contribution limits?
2. Do you think the tax brackets will be the same during the next year you’d be eligible for a rollover Roth conversion? (That next year would be either the year you turn 59 1/2 or the year you retire, whichever is sooner.)

If the answer is yes to both, then you can save fees by using the cheaper Schwab i401(k) offering.

If not, do the potential benefits of the Roth deferrals, in-plan Roth conversions, and/or after-tax contributions available under the MySolo401k offering offset the additional fees?

Because the future is uncertain, there is not one right answer to this question.

Photo by Carrie Beth Williams on Unsplash. Image has been cropped.