My client who was solo proprietor, changed his business structure to an S-Corp. In doing so his CPA suggested that he change from a SEP IRA to a Solo 401K options. He only 41, so I’m not sure what the benefit would be to switching. I would appreciate the insight. Thank you
There is nothing inherent in the change to an S-Corp, that favors a one-participant 401k over an SEP IRA.There are pros and cons of each employer retirement plan independent of the business entity type.If the client is not maximizing their employee deferral limit, the 401k may allow greater contributions on lower compensation than a SEP IRA.
If the client is phased out of direct Roth IRA contributions by the Roth MAGI limit. One participant 401k pre-tax contributions do not interfere with a little to no tax liability Backdoor Roth. In fact a one participant 401k provides a safe destination to rollover any and all pre-tax balances in all traditional, SEP and SIMPLE IRA accounts.
However, a one-participant 401k is still a full-fledged 401k plan with significant compliance requirements. Specifically, the requirement to file Form 5500-EZ when the 401k plan balance is >= $250K and the end of any year and/or when terminating the plan.
Also, a 401k has restrictive in-service distribution limitations. Where distributions from a SEP IRA can be taken at any time subject to ordinary income taxes and the 10% early penalty prior to age 59 1/2 with exceptions.
Are we sure that the change to an S-Corp is actually beneficial. Unfortunately we have seen many cases where the change is counter-productive.An S-Corp has to pay substantially less W-2 wages to justify its existence based on FICA tax savings. Employer contributions are based on compensation. An S-Corp will have lower compensation than an equivalent sole proprietorship. This will result in lower retirement plan employer contributions.
An S-Corp can actually result in higher net FICA taxes for an individual who has exceeded the SS maximum taxable earnings than SE taxes as a sole proprietor.
In an SSTB with eligible taxable income. An S-Corp will have a far lower QBI deduction than an equivalent sole proprietorship.
The only way a non-SSTB > the W-2 wage limit can take the QBI deduction is to be an S-Corp.
Neither of these is an exhaustive list. These are complicated interactions and unfortunately some CPAs shoot from the hip on employer retirement plan and business entity selection without modeling all of the pros and cons of each.
Permalink Submitted by Alan - IRA critic on Wed, 2021-03-03 20:50
An S Corp owner can only contribute 25% of W-2 compensation to a SEP IRA, but with a solo K could contribute up to 19,500 or 100% of wages plus a profit sharing contribution up to 25% of W-2 comp. Both plans would be subject to an overall cap of 58,000 and a compensation cap of 290,000. Therefore, contributions can be much larger using a solo K.