Is Your SEP Underserving Your Needs? Here Are Some Options to Consider.

Client Case Background

As business owners near retirement, they often outgrow their Simplified Employee Pensions (SEP) and SIMPLE IRAs. For many self-employed individuals, there is a case to be made for why your SEP may be underserving you. In these cases, we often advise in favor of a solo 401(k) plan to fully maximize your opportunity, especially if you are a high-income earner.

Converting a SEP IRA into a solo 401(k) allows a self-employed individual to contribute more to their retirement savings than the limitations of a SEP IRA allow. A solo 401(k) typically offers higher contribution limits and the ability to make both employee and employer contributions, whereas a SEP IRA allows only employer contributions.

DBR & CO advisors have helped clients work through the process of opening the plan, getting documents set up and even funding the plan. Recently, a client with a unique situation engaged us for just such a strategy. The long-time client is a successful investor and business owner. However, most of their assets are tied up in real estate instead of traditional retirement savings plans. They have a high net worth, and are currently in a high tax bracket. They are now looking to divest from their real estate holdings, but any traditional exit strategy would involve significant capital gains and subsequently large tax liabilities.

Assessing the Task at Hand

With a goal of minimizing taxes while maximizing growth potential of their assets, in accordance with their broader financial plan, we had to consider the following features of a solo 401(k):

A solo 401(k) allows for larger annual contributions compared to a SEP IRA, which is capped at a percentage of your net income. Contributions to a SEP can’t exceed 25% of compensation, (the lesser of 25% or $69,000 in 2024) so, it’s limited to a percentage of net income. Whereas the maximum contribution for a solo 401(k) is $76,500 (plus a $7,500 catch-up if over age 50). In a scenario where someone is earning $200k per year, a SEP allows for saving just 25% ($50,000) versus $76,500 in a solo 401(k). A solo 401(k) also provides the ability to do a backdoor Roth IRA.

Tackling the Problem

The opportunity to execute Roth conversions and gain additional tax diversification was paramount in our discussions with this client. Timing was also critical in putting together a successful program. We put the full amount of their earnings into the after-tax bucket, then immediately converted their account to the Roth bucket in the solo 401(k). More precisely, this strategy is known as a mega backdoor Roth 401(k) contribution. This strategy can allow someone who would be ineligible to contribute to a Roth IRA based on their income or contribution limits to transfer certain types of 401(k) contributions into a Roth.

Achieving Positive Outcomes

The approach allowed our client to make backdoor Roth IRA contributions immediately, allowing the assets to grow tax-free. They can then contribute each year going forward. Our strategy allows them to save both pre-tax and post-tax, while allowing for broader contributions and greater flexibility.

There is also great news for those who are past retirement age. If you want to work until 70, or become a consultant for example, the rollover of your retirement account into a solo 401(k) can delay any Required Minimum Distributions (RMDs).

If you want to unlock a source of tax efficient savings, we can work with your CPA to discuss whether such a strategy is right for your situation. We can also provide a second opinion on what your CPA has in place.

If you are a CPA, we have a number of ideas to share with your clients who maintain SEPs and want to save more for retirement. We can also help if you have clients who are heading toward retirement and have self-employed income that they want to invest in appropriate retirement accounts and diversify their taxes.

Conclusion

Our clients who are small business owners and entrepreneurs have several different types of retirement plans they utilize to grow and accumulate retirement savings. As their businesses age, it is common for us to discuss whether alternative plans may be a better fit when it is time to cash in or begin their retirement. When transitioning between retirement plan types, we work with our clients’ CPAs to help terminate the existing plan, establish the new plan and ensure that the transition is done within IRS guidelines.

If you have questions about whether your current SEP or Simple IRA is still appropriate for the next phase in your retirement journey, please feel free to reach out to discuss your situation.

Thanks for reading.