Solo 401(k), SEP-IRA Or Company Plan: Retirement Saving For Founders
Founders often skip retirement saving because the company feels like the plan. Here is how the main account types work and what changes as you hire.
A lot of founders treat the company as their retirement plan. It is an understandable instinct and a risky one. If the company works, a retirement account is a modest addition. If it does not, that account may be the only long-term savings you have.
The tax code offers founders several ways to save for retirement through their business, and the right one depends on how the business is structured and whether you have employees. Contribution limits change most years, so check current figures with the IRS; the mechanics below are what matter for choosing.
Solo 401(k) versus SEP-IRA
A one-participant 401(k), often called a solo 401(k), is designed for a business owner with no employees other than the owner and a spouse. Its appeal is that you contribute in two capacities.
As the employee, you can make elective deferrals from your compensation, either pre-tax or as Roth contributions if the plan allows. As the employer, the business can add a profit-sharing contribution based on your compensation. Together these can allow higher total contributions than many other options at moderate income levels.
The plan is a real 401(k), so it comes with paperwork. Once plan assets pass a threshold set by the IRS, an annual information return is generally required. Plans are usually set up through a brokerage or a plan provider for a modest fee. Compare what investments each provider offers inside the plan, because a cheap plan with expensive fund choices is not cheap.
A simplified employee pension, or SEP-IRA, is easier to run. Only the employer contributes, as a percentage of each eligible person's compensation, up to an annual limit. There is no employee deferral, and there is generally no annual filing for the plan.
The trade-off is that, at lower and middle income levels, a SEP may allow smaller contributions than a solo 401(k), and there is no Roth employee deferral. The bigger issue arrives when you hire: a SEP generally requires the business to contribute the same percentage of pay for eligible employees as it does for you.
How your entity changes the math
What counts as compensation for these plans depends on your entity. Sole proprietors and partners generally calculate contributions from net earnings from self-employment, after certain adjustments. S corporation owners calculate from their W-2 wages, not from distributions.
That last point catches S corporation owners who keep their salary low and take most of their income as distributions. Distributions do not count, so a low salary also means a low ceiling on retirement contributions. It is one more input when you decide what reasonable compensation should be.
When the company starts hiring
Once you have employees who meet the eligibility rules, a solo 401(k) is no longer the right vehicle, and a SEP becomes more expensive because employees must be included. At that point most growing companies move to a standard 401(k) or a SIMPLE IRA run through a payroll or plan provider.
For venture-backed startups, the question usually becomes which 401(k) provider to use and whether to offer an employer match. Founders who are employees of their C corporation participate in that plan like everyone else, subject to nondiscrimination testing that limits how much the plan can favor highly paid employees.
Deadlines, and pre-tax versus Roth
The deadlines for setting up and funding each plan type differ, and recent legislation changed some of them, particularly for new plans and sole proprietors. Do not assume you can open an account in April and count it for the prior year. Check the current rules for your plan type before the end of the tax year.
Contributions are only half the decision. Pre-tax contributions reduce taxable income now and are taxed on withdrawal; Roth contributions are taxed now and can be withdrawn tax-free later if conditions are met. Founders with a low salary today and a hoped-for higher income later sometimes favor Roth for that reason, but that is a projection worth running with an adviser.
What to do before year end
Confirm your entity type and how your compensation for plan purposes is calculated. If you have no employees, compare a solo 401(k) and a SEP-IRA at your actual income level. If you have employees or plan to hire soon, ask a provider about a plan that can grow with the company.
Then automate it. A monthly contribution set up once is far more likely to happen than a lump sum you intend to make in a good month that never quite arrives.
This is general information, not tax advice. Rates and thresholds change; confirm current figures with the agencies linked below or with your accountant.
