Sep IRA vs Solo 401k and Pro-rata rule and timing

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cpan00b
Posts: 147
Joined: Wed May 10, 2017 9:39 pm

Sep IRA vs Solo 401k and Pro-rata rule and timing

Post by cpan00b »

Hello all - 2022 was my first year as a self employed freelancer (part of the year was as a W-2 employee as well) and I am trying to figure out retirement accounts now. See below for details.

Employed as W2 in 2022:

- I have an existing pre-tax 401k account that has been open since 2017.

- In 2022, I maxed out this 401k account ($20,500 for my employee contribution, $8000 with my employer match and another $20,000 since my employer plan allowed an after-tax extra contribution)

- I have a separate ROTH IRA account, for which I do a back-door roth contribution every year since my income is too high. In 2022 I contributed $6000 as a backdoor contribution.

Freelance 1099 in 2022:

- I quit my W2 job half way through the year and started consulting. My Gross income for this was $15,065. After deducting business expenses, my net income is $13,333. Note this does not take into account any self-employment taxes or deductions for retirement.



Question 1: Should I open an SEP IRA now (for 2022). I understand that I have until April 15, 2023 to contribute for 2022 still. Based on my understanding, I will be able to contribute about 20% of my net income from the 1099. Will this have any negative consequences on the activities I did in connection with my W2 above? If SEP IRA counts as a traditional IRA, my understanding is that roth ira back door conversion in the future will have to take into account the pro rata rule. However, for 2022 it will have no effect because the calculation is based on the IRA balance on 12/31/22, so since I am contributing to the SEP IRA now, it will not affect by Roth backdoor from earlier in 2022.


Question 2: For tax year 2023, I will be 1099 consulting the entire year. I expect to have gross revenues over $100,000 so I plan to open a solo 401k for 2023. What happens to the SEP IRA that I will have from 2022 above? My plan is to try to roll it over into my solo 401k later this year. I would just open a solo 401k and skip all of this but my understanding is that it is too late to contribute to a solo 401k now for 2022.

Thanks!
peteyboy
Posts: 402
Joined: Tue Feb 07, 2023 2:26 pm

Re: Sep IRA vs Solo 401k and Pro-rata rule and timing

Post by peteyboy »

Sounds like you're just looking for some level of confirmation per Question 1: You are ok to open the SEP IRA this year and contribute 20% of the $13,333 as the employER for 2022 and then do as you suggest in 2023 (Question 2), rolling it into your s401k, assuming the s401k you set up allows rollover contributions.

Yes, it's too late to open the s401k for 2022 contributions, as you indicate.

FYI...there are several s401k contribution calculators available online - here is one: https://obliviousinvestor.com/solo-401k ... alculator/

Personally, I'd skip the 2022 SEP IRA step and focus on 2023 and beyond...but thats just me, of course.

One of the nice things about the s401k plans is you can set up the ROTH option as well, at least thats the case with Vanguard - not sure about other providers. For setting up the Vanguard s401k you do need a EIN - but thats easy to get from the IRS, only takes 10 minutes.
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Duckie
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Joined: Thu Mar 08, 2007 1:55 pm

Re: Sep IRA vs Solo 401k and Pro-rata rule and timing

Post by Duckie »

cpan00b wrote: Wed Mar 22, 2023 6:36 am Should I open an SEP IRA now (for 2022). I understand that I have until April 15, 2023 to contribute for 2022 still. Based on my understanding, I will be able to contribute about 20% of my net income from the 1099. Will this have any negative consequences on the activities I did in connection with my W2 above?
You will be contributing as the employER and there would be no issues with your W-2 contributions.
If SEP IRA counts as a traditional IRA, my understanding is that roth ira back door conversion in the future will have to take into account the pro rata rule. However, for 2022 it will have no effect because the calculation is based on the IRA balance on 12/31/22, so since I am contributing to the SEP IRA now, it will not affect by Roth backdoor from earlier in 2022.
I'm not sure about that. Even though the non-existent SEP IRA would have had a balance of $0 as of 12/31/2022, you are contributing FOR 2022. If this were a TIRA (you converted in 2022 and made a TIRA contribution for 2022 in 2023) pro-rata would definitely apply. I'm not sure being a SEP IRA instead of a TIRA clears the hurdle.

Even if there is no pro-rata issue, if you open the SEP IRA and contribute the 20% for 2022 it will be around $2500. Then you will have to transfer it to the new solo 401k (making sure the plan allows for incoming rollovers) to continue the backdoor Roth process. Is that amount worth the hassle?
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