solo 401k, SEP IRA or roth 401k?

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sam_likh
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Joined: Wed Jun 21, 2017 2:55 pm

solo 401k, SEP IRA or roth 401k?

Post by sam_likh » Wed Jun 21, 2017 3:08 pm

Hi All-
My first time asking a question here.

My wife is a freelancer and she expects to make about 45K this year with low to no overhead.
Last year she made only about 13K.
We file our taxes MFJ.
Last year, our AGI was 136K
We both contributed to the full amount towards Roth IRAs.

Now, we are contemplating if we should open solo 401k or just do SEP IRA.
I am leaning towards solo 401k since we can contribute 18K employee deferral and 25% of net freelance income.
But then I also read that Roth solo 401K is also an option.

I am confused and would appreciate any advice here as to what is the best option for us.

Thank you

nervouscorps
Posts: 36
Joined: Sun Jan 05, 2014 8:01 pm

Re: solo 401k, SEP IRA or roth 401k?

Post by nervouscorps » Wed Jun 21, 2017 7:01 pm

I was just dealing with this very issue for my wife who is a private practice therapist. Our financial advisor explained that if we anticipate her earning more over the years (we do) and our taxable income to increase towards retirement (we do) a Roth 401k makes sense.

Spirit Rider
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Joined: Fri Mar 02, 2007 2:39 pm

Re: solo 401k, SEP IRA or roth 401k?

Post by Spirit Rider » Wed Jun 21, 2017 7:19 pm

A one-participant 401k clearly gives her the ability to make greater retirement plan contributions. There is a maximum employee deferral of $18K ($24K >= age 40), For a sole proprietor the maximum employer contribution is 20% of net self-employment income (net business profit - 1/2).

Whether to make traditional (pre-tax) or Roth (post-tax) 401k employee deferrals is a decision primarily driven by a determination of current tax rate vs. retirement tax rates. Even with pre-tax 401k deferrals and likely exemptions and deductions, you are probably solidly in the 25% marginal tax bracket. Most Bogleheads would recommend pre-tax traditional 401k deferrals in your circumstances.

So my recommendation is a one-participant 401k using traditional pre-tax employee deferrals. Employer contributions are always pre-tax. Your Roth IRA contributions are because with your MAGI you are not eligible to make deductible IRA contributions. If you can not maximize both the one-participant 401k contributions and the Roth IRA contributions, it is a more difficult decision, because there are other benefits of Roth IRA contributions.

Note: Vanguard does not allow you to use Admiral Shares in their Individual 401k. This results in higher expense ratios than you can get at Fidelity, Schwab, TD Ameritrade, etc...

J295
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Re: solo 401k, SEP IRA or roth 401k?

Post by J295 » Wed Jun 21, 2017 9:47 pm

I like the solo 401k. We use Fido.

sam_likh
Posts: 3
Joined: Wed Jun 21, 2017 2:55 pm

Re: solo 401k, SEP IRA or roth 401k?

Post by sam_likh » Thu Jun 22, 2017 8:06 am

Thank you- yes I am leaning towards traditional solo 401k, will stay away from roth. So just so that my understanding is right:

- With expected 45K income for my wife, we can max out 18K employee deferral in solo 401K
- Additional 25% of her net income (gross less expenses), can be contributed as the employer (did not understand "net business profit - 1/2"?)
- On top of the above, we can still do Roth IRA contribution of $5500 for her

So not having access to admiral shares, results in higher expense ratio at VG. So do you recommend we do not open solo 401k with VG but instead open with Fidelity? What are the pros and cons of this?

Lastly, what is "Fido"?

Thanks again.

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BolderBoy
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Re: solo 401k, SEP IRA or roth 401k?

Post by BolderBoy » Thu Jun 22, 2017 8:26 am

sam_likh wrote:Lastly, what is "Fido"?
Shorthand for "Fidelity".
"Never underestimate one's capacity to overestimate one's abilities" - The Dunning-Kruger Effect

Spirit Rider
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Joined: Fri Mar 02, 2007 2:39 pm

Re: solo 401k, SEP IRA or roth 401k?

Post by Spirit Rider » Thu Jun 22, 2017 9:29 am

sam_likh wrote:Thank you- yes I am leaning towards traditional solo 401k, will stay away from roth. So just so that my understanding is right:

- With expected 45K income for my wife, we can max out 18K employee deferral in solo 401K
Yes, for 2017 the employee deferral limit is 100% of compensation up to $18k ($24K >= age 50).
- Additional 25% of her net income (gross less expenses), can be contributed as the employer (did not understand "net business profit - 1/2"?)
The maximum employer contribution is 25% of compensation. For a W-2 employee this is typically their W-2 wages before any pre-tax deferrals and the pre-tax employee share of any Cafeteria Plan deductions.

Compensation for a sole proprietor is their net business profit - the adjustment to income for 1/2 the SE tax. The IRS refers to this as net earnings from self-employment on the Deduction Worksheet for Self-Employed in IRS Publication 560 Retirement Plans for Small Business.

However, as explained in this publication and demonstrated in the worksheet. The employer contribution itself is deducted from the net self-employment income (base compensation) to arrive at the true compensation. This is because the employer contribution is made by the employer even if you and the employer are the same.

The calculation would be recursive it you tried to do it directly, so the IRAS uses a little algebra to calculate it directly. This formula is plan contribution rate (25%) / (1 + 25%) = 0.25 / 1.25 = 0.20 = 20% of net self-employment income (net business profit - 1/2 SE Tax).
- On top of the above, we can still do Roth IRA contribution of $5500 for her
Yes, the 401k contributions by and of themselves do not interfere with Roth IRA contributions. The requirements for a Roth IRA are that the individual has sufficient compensation by themselves or if not their spouse to make a spousal contribution and their MAGI (MFJ in this case) is below the maximum.
So not having access to admiral shares, results in higher expense ratio at VG. So do you recommend we do not open solo 401k with VG but instead open with Fidelity? What are the pros and cons of this?
Vanguard offers widest variety of index mutual funds and the Roth 401k option, but does not offer their lowest cost Admiral shares, rollovers and employee eligibility criteria.

Fidelity has a reasonable number of index mutual funds for most asset allocations, offers their lowest cost Premium class shares, offers rollovers and employee eligibility criteria, but no Roth 401k option.

TD Ameritrade and Schwab are two other low cost options for one-participant 401k plans.
Last edited by Spirit Rider on Thu Jun 22, 2017 6:13 pm, edited 1 time in total.

sam_likh
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Joined: Wed Jun 21, 2017 2:55 pm

Re: solo 401k, SEP IRA or roth 401k?

Post by sam_likh » Thu Jun 22, 2017 10:31 am

This is great information- I really appreciate it.

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