SEP IRA vs Solo 401k for side hustle

[Jennifury]

Hi!
I 'retired' at the beginning of this year (mid 30s) but my husband is still working a six figure job. We are what I'd consider FI-lite and he plans on continuing to work for several more years because he and I have differing desired spending levels in retirement. He maxes out his 401k as well as does some back door Roth conversions and contributes maximally to a personal Roth IRA. We also make monthly contributions to a taxable investment account, max out an HSA that we don't use for current health care costs, have an investment property, and contribute to 529s for our children.

I have been doing a small amount of side hustling under a LLC I made earlier in the year. I've made about 10k but I don't plan on trying to grow the business at all and expect to make 10-20k a year with it (kids, volunteering, and fitness goals are my priorities).

It's getting to the end of the year and I really need to decide what to do with the money sitting in my business account. In April I talked with our tax professional and she got me kind of mixed up about it and I'm looking for some guidance. I want to dump as close to 100% of the profits of my LLC as I can into a tax advantaged account.  I'd prefer a Roth style account (we are fairly heavily weighted in pre tax accounts currently) but a pre tax account is fine if Roth isn't as viable. My tax lady was really promoting SEP IRAs but from what I understand of what I read I can't put anywhere close to 100% of the profits in there. Am I missing something?

My first inclination had been to set up a solo Roth 401k with vanguard. I've heard mention that they are more legally complicated but I am not sure what that entails.

Can anyone share experience with either of these two options, or another option that I am maybe overlooking? What are the administration challenges, tax implications, etc with these for both me as an individual as well as the LLC?

[Jennifury]

Oh! Also, does the SEP IRA or solo 401 K prevent me from contributing to a personal roth IRA?

[terran]

As long as you and your husband don't plan to start a business with employees then a solo 401(k) offers a higher contribution limit for most people and isn't that complicated.

Having either account will switch you from having a spouse with a workplace retirement plan to having a workplace retirement plan yourself, which can effect you eligibility for IRA contributions depending on total income, but the additional solo 401(k) space should make up for that at 10-20k of income.

Vanguard is a good option for Roth solo 401(k), but if you want Roth solo 401(k) as well as being able to rollover a traditional IRA into the 401(k) then look at Etrade and TD Ameritrade as well. I switched from Fidelity to Etrade to have access to Roth. Being able to roll a traditional IRA into the 401(k) could be useful if your income is too high to contribute directly to a Roth IRA is it could let you make backdoor Roth IRA contributions without the traditional IRA getting in the way.

[dandarc]

Curious why Roth? Just like to know the reasoning behind that decision - at a "6 figure" income, going traditional in 401Ks and the like is often but not always the best move. For things like "can I deduct a traditional IRA?", going traditional in a 401K can potentially help the answer be "yes".

In any event, At $10-20K / year, a Solo 401K should allow you to contribute nearly all of your side-business income assuming you don't have some other job where you're maxing out the employee contributions. Whereas a SEP would be employer-side only and limit you to 20% of profit if you're taxed as a proprietor or 25% of W-2 if taxed as a corporation, so you'd be able to contribute less. No Roth option with a SEP since it is employer-contributions only.

I use Etrade for my solo K. Ironically, I initially set it up there because at the time it was one of the few that offered a Roth option. By the 2nd year, I had seen the light on Traditional being better for us so "has Roth option" no longer factors into the reasoning. Etrade currently has the good Schwab index funds on the no-transaction fee list, so I have no reason to move elsewhere.

[terran]

Curious why Roth? Just like to know the reasoning behind that decision - at a "6 figure" income, going traditional in 401Ks and the like is often but not always the best move. For things like "can I deduct a traditional IRA?", going traditional in a 401K can potentially help the answer be "yes".

One possible reason is that Roth solo 401(k) contributions do not reduce the new Qualified Business Income deduction while tax deferred contributions do. That still might not be enough to change the decision, but it does change the math. The marginal tax rate savings goes from the 22% bracket to a 17.6% bracket and the 12% bracket to a 9.6% bracket for example.

[dandarc]

Curious why Roth? Just like to know the reasoning behind that decision - at a "6 figure" income, going traditional in 401Ks and the like is often but not always the best move. For things like "can I deduct a traditional IRA?", going traditional in a 401K can potentially help the answer be "yes".

One possible reason is that Roth solo 401(k) contributions do not reduce the new Qualified Business Income deduction while tax deferred contributions do. That still might not be enough to change the decision, but it does change the math. The marginal tax rate savings goes from the 22% bracket to a 17.6% bracket and the 12% bracket to a 9.6% bracket for example.

That's a good point - in OP's situation, seems likely that all of the income would qualify for QBI.

[terran]

Curious why Roth? Just like to know the reasoning behind that decision - at a "6 figure" income, going traditional in 401Ks and the like is often but not always the best move. For things like "can I deduct a traditional IRA?", going traditional in a 401K can potentially help the answer be "yes".

One possible reason is that Roth solo 401(k) contributions do not reduce the new Qualified Business Income deduction while tax deferred contributions do. That still might not be enough to change the decision, but it does change the math. The marginal tax rate savings goes from the 22% bracket to a 17.6% bracket and the 12% bracket to a 9.6% bracket for example.

That's a good point - in OP's situation, seems likely that all of the income would qualify for QBI.

I think you might be referring to the situation where making tax deferred contributions lower your income enough make you eligible for the QBI deduction despite being a specified service business and having a high household income?

I a was actually referring to the situation where your income is low enough and/or you're not a specified service business, in which case making tax deferred contributions actually lower your deduction because tax deferred contributions made to a plan connected to the business reduce QBI, which reduces the deduction.

[dandarc]

I think we're saying the same thing. Marginal rates are lower for traditional contributions due to losing QBI deduction. In OP's case, the business income is the limiting factor for QBI.

QBI deduction wasn't really a well thought out thing. For us, the QBI deduction increases for every dollar my wife makes. She's in school and working part time; as mentioned, I'm still in full-on traditional mode, so the taxable income is lower than the business income even though we're a two-income household. Then she's not covered by a retirement plan, so I'm doing a full tIRA for her regardless (income high, but not so high as that becomes a problem). QBI deduction feels like a random gift from the tax code for us.

[terran]

Gotcha, in your case with high self employment income and low other income QBI is limited by the total taxable income limit, so traditional solo 401(k) makes sense. In the OP's case with low self employment income and high other income Roth solo 401(k) might make sense. Although even with the lower marginal tax savings, traditional could still make sense depending on expected marginal tax rates in retirement, so your question about whether Roth makes sense for her is still a valid question.

[Jennifury]

I think we're saying the same thing. Marginal rates are lower for traditional contributions due to losing QBI deduction. In OP's case, the business income is the limiting factor for QBI.

QBI deduction wasn't really a well thought out thing. For us, the QBI deduction increases for every dollar my wife makes. She's in school and working part time; as mentioned, I'm still in full-on traditional mode, so the taxable income is lower than the business income even though we're a two-income household. Then she's not covered by a retirement plan, so I'm doing a full tIRA for her regardless (income high, but not so high as that becomes a problem). QBI deduction feels like a random gift from the tax code for us.

This is great feedback, thanks!

I initially preferred a roth mostly because I want to be able pull from different buckets during retirement to avoid hitting income thresholds in the tax brackets. Our portfolio is currently skewed a lot towards pre tax accounts and I was interested in giving us more flexibility in the future, especially since my husband desires a higher spend rate. Also while we have been high earners, we have always been able to take advantage of a significant amount of deductions so our current tax rate is fairly low and I personally expect tax rates to go up considerably in the future.

[Jennifury]

If I do the solo roth 401k does it matter if I make the contributions as the employer + employee vs employee only contributions?

[terran]

If I do the solo roth 401k does it matter if I make the contributions as the employer + employee vs employee only contributions?

Only employEE contributions can be made to Roth. EmployER contributions are always tax deferred. It's only when income goes over the salary deferral limit (2019 = 19k, 2020 = $19.5k) that this matters since you can just make all your contributions employee salary deferral contributions to Roth. It's actually a little more than over that amount as you have to reduce income for 1/2 of self employment tax.

Also remember to claim an expenses you're eligible for (mileage and home office can be especially good ones if eligible) since that avoids paying self employment tax as well as income tax.