Is a SEP IRA or Solo 401(k) better when you want to maximize your Section 199A Qualified Business Income deduction? Here’s what you need to know.
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This post is provided for general information only. Please confirm the details and circumstances of your unique situation with your tax accountant or other appropriate advisor before taking action.
What’s the Section 199A Qualified Business Income Deduction?
The QBI deduction is the 20% deduction for pass-through business owners from the 2018 Tax Cuts and Jobs Act. The basic idea is that if you have a sole proprietor, partnership, LLC, or S-corporation, you only pay income tax on 80% of your profits. This can include both full-time businesses and gig economy 1099 jobs like rideshare driving and reffing sports.
SEP IRA vs. Solo 401(k) Traditional Considerations
To understand what’s different with the QBI deduction in play and whether it’s important to you, let’s review the traditional considerations when choosing between a SEP IRA and Solo 401(k).
- Ease of opening: Many providers allow you to open a SEP IRA instantly online like a personal IRA or bank account. Solo 401(k)s virtually always require mailed or faxed forms.
- Ease of contributions: Most SEP IRAs allow you to schedule automatic withdrawals from a personal or business bank account and make changes at any time. Solo 401(k)s often have restrictions on the bank account you can use, may require you to mail or fax a form to make changes, and some even require a physical check for contributions.
- Opening deadline: You have to open a Solo 401(k) by the end of the tax year (usually December 31st). You have to open a SEP IRA by the time your tax return is due (usually April 15th). This gives you more time to open a SEP IRA.
- Cost: There are many free SEP IRA options available. Most Solo 401(k)s have setup and/or ongoing administration fees.
- Investment options: SEP IRAs are usually an unrestricted brokerage account allowing you to use your choice of stocks, ETFs, and mutual funds. Some solo 401(k)s have a brokerage option, while others require you to choose from a fixed list of mutual funds.
- Employee contribution limits: Solo 401(k)s allow you to contribute up to $19,000 as an employee. SEP IRAs do not allow employee contribution limits, although many SEP IRAs can also accept your regular personal IRA contributions into the same account.
- Employer contribution limits: Both SEP IRAs and Solo 401(k)s allow you to contribute up to 20% of your compensation as the employer.
- Roth option: Solo 401(k)s allow a pre-tax deductible option and a post-tax Roth option. SEP IRAs do not allow a Roth option, although you can convert your contributions to your Roth IRA if you choose to do so.
Based on that information, most people chose SEP IRAs. The most compelling reasons to go with a Solo 401(k) were if you wanted the higher employee contribution limits or if you wanted the Roth option.
What Changes with the QBI Deduction?
The biggest wrinkle in the current tax code is that retirement contributions you make as an employer reduce your qualified business income, but contributions you make as an employee don’t.
Example: Your qualified business income is $60,000 per year and you want to save 10%.
- If you put $6,000 into a personal IRA or into a Solo 401(k) as an employee, your QBI is still $60,000, and your QBI deduction is $12,000.
- If you put $6,000 into a SEP IRA or into a Solo 401(k) as an employer, your QBI is reduced to $54,000, and your QBI deduction is $10,800.
Therefore, you want to prioritize personal IRA and Solo 401(k) employee contributions over SEP IRA and Solo 401(k) employer contributions to get a bigger tax deduction.
What About Roth Contributions?
Since you can only make Roth contributions into the employee portion of your Solo 401(k) or into a personal Roth IRA, they don’t directly impact your QBI deduction.
However, the QBI deduction makes Roth contributions more valuable. The QBI deduction does not apply to taxable distributions from your retirement account. If you skip it to make tax-deductible retirement contributions, you lose it.
Example: You’re in the 22% tax bracket and will be in retirement.
- If you choose the Roth option and pay the tax this year, your effective tax rate after the 20% deduction is 17.6% (22% x 80%).
- If you choose the deductible option, you pay the full 22% tax rate in retirement.
Remember, the usual rule for Roth contributions is to use them when you expect your tax rate today to be lower than your tax rate in retirement.
What About Roth Conversions?
In the past, if you wanted to do Roth contributions and not deal with the hassle of a Solo 401(k), you could contribute to a SEP IRA and convert it to a Roth IRA in the same year. Your deduction for the SEP IRA and the tax on the conversion offset each other, so it was like you just contributed to a Roth IRA in the first place.
Currently, you lower your QBI deduction by doing so. The SEP contribution reduces your QBI deduction as usual. The conversion is taxed as ordinary income without the benefit of the QBI deduction.
- $10,000 employee contribution to a Solo 401(k): receive a $2,000 QBI deduction (20% x $10,000) and pay income tax on $8,000 ($10,000 – $2,000).
- $10,000 contribution to SEP IRA converted to a Roth 401(k): $10,000 is deducted from your business income, so no QBI deduction. The conversion is taxed as ordinary income, so you still pay income tax on $10,000 ($10,000 – $0).
With the QBI deduction in play, Solo 401(k)s give you more tax maneuverability that may make them worth the hassle when they weren’t in the past. However, SEP IRAs are still the easier option if you don’t need to make one of the above moves or think the tax benefit doesn’t outweigh the extra hassle.