Solo K, Simple, Sep IRAs, The Need to Knows

At www.obliviousinvestor.com, you can read about these 3 types of accounts. Here are some extra notes. Please consult a tax advisor before making any decisions about which account to use.

SEP

SEP accounts require employers to contribute the same percentage to all employees based on their salary, according to www.irs.gov. This plan is useful as a profit sharing mechanism.

For a SEP account, your tax deductible contribution must satisfy the following two equations:

C1 < .25*(P - .5*T - C1)
C1 < 51,000

where C1 represents the employer contribution, P represents the profit (revenue - expenses) and T represents the self employment tax. According to www.obliviousinvestor.com, self employment tax includes 12.4% for Social Security tax and 2.9% for the Medicare tax, which is 15.3% in total. Therefore, T=.153*P. Simplifying the equations, we get:

C1 < .1847*P
C1 < 51,000

So, roughly speaking, for a SEP, the business owner's tax deductible contribution must be less than 18% of your profit (and is capped at $51,000).

SIMPLE

SIMPLE plans can include businesses with up to 100 employees. Unlike the SEP, which has a 10% penalty for early withdrawl (like a Traditional IRA) before age 59 1/2, the SIMPLE has an early withdraw penalty of 25%. According to www.irs.gov, normal simple plans are used to match employer contributions or share profit so they will have either:

A) a match elective contribution with the employer matching up to 3% of the employee's salary
B) a profit sharing non-elective contribution with the employer gifting employees 2% of the employee's salary

The following equations regulate the employer and employee contributions:

C1 < .03*(P - .5*T - C1)
C2 < (P - .5*T - C1)
C2 < 12,000

where C1 represents the employer contribution, P represents the profit, T represents the self employment tax and C2 represents the employee contribution. To create a guideline, we will assume the maximum employer contribution is made for C1, although if it isn't the employee contribution C2 could be larger. So for the second equation, we will use an estimate from the first equation: (P-.5*T-.027705*P) < (P - .5*T - C1). This simplifies the equations to:

C1 < .027705*P
C2 < .895795*P
C2 < 12,000

So, roughly speaking, for a SIMPLE, the business owner's tax deductible contribution must be less than about 92.35% of your profit (and is capped at about $12,000 plus 2.75% of your profit).

SOLO K

SOLO K (aka Individual 401K) plans are typically for businesses without any employees. There are also exceptions made for when the only other employees that would qualify to make contributions are the owner's spouse. See mysolo401k.blogspot.com for guidelines.

These equations regulate the contributions for the account:

C1 < .25*(P - .5*T - C1)
C1 < 51,000
C2 < (P - .5*T - C1)
C2 < 17,500

where C1 represents the employer contribution, P represents the profit, T represents the self employment tax and C2 represents the employee contribution. For the second equation, we will again use an estimate from the first equation: (P-.5*T-.1847*P) < (P - .5*T - C1).

C1 < .1847*P
C1 < 51,000
C2 < .7388*P
C2 < 17,500

So, roughly speaking, for a SOLO K, the business owner's tax deductible contribution must be less than 92.35% of your profit (and is capped at about $68,500). In addition, the employee contribution can be after tax, using the ROTH provision of a SOLO K (capped at about $17,500).

This post was reposted from http://finlit.biz/business/solo-k-simple-sep-iras-the-need-to-knows/, originally written on May 2nd, 2014.