- When you're starting your journey as a locum tenens physician, one tax-saving strategy your accountant might suggest is setting up a SEP-IRA retirement account. Contributions to a SEP-IRA can significantly reduce your tax burden for the year in which they're made. However, there are alternative options that are equally straightforward to manage and offer the potential for higher contribution limits. The Solo 401(k) (also known as the Individual 401(k)) emerges as a strong contender against the widely praised SEP-IRA and may be the preferred choice for locum tenens doctors or travel nurses.
But first, let's clarify what a SEP-IRA entails.
A SEP-IRA is a retirement plan where the employer makes contributions for each eligible employee. As a self-employed locum tenens provider, you can establish this plan for yourself, with the business making contributions on your behalf as the sole employee. The plan permits employer contributions limited to the lesser of 25% of compensation or $69,000 for 2024. Contributions are made with pre-tax dollars, thus reducing your taxable income. Beginning in 2023, there's also a Roth SEP-IRA option, allowing after-tax contributions where you don't receive a tax deduction upon contribution, but earnings and withdrawals at retirement are tax-free, akin to a Roth IRA.
The Solo 401(k) Offers Potential for Greater Deductions
While the SEP-IRA is indeed a valuable tax-saving tool, the Solo 401(k) might offer even more significant tax benefits. This is particularly true if your compensation from your locum tenens side-gig wouldn't fully utilize the $69,000 contribution limit with the 25% of compensation contribution allowed by the SEP-IRA. The Solo 401(k) shares the same 25% compensation employer contribution feature but additionally allows for employee contributions (known as elective deferrals). Employee contributions enable a dollar-to-dollar compensation-to-contribution match, up to the lesser of 100% of employee compensation or $23,000 for 2024 ($7,500 additional catch-up contributions if 50 years or older). (“Retirement Plans for Self-Employed People | Internal Revenue Service”)
The combined employee and employer total contributions cannot exceed the $69,000 limit ($76,500 including catch-up contributions). You have the flexibility to decide how much you want to contribute in either employee and/or employer contributions. Additionally, Solo 401(k)s may offer a third bucket for voluntary after-tax contributions, significant for executing the mega backdoor Roth IRA conversion.
For the purposes of this article, we won't delve into defining compensation for the self-employed, as this varies depending on tax election, nor will we explore the details of the mega backdoor Roth IRA conversion. Catch-up contribution limits will also be disregarded for the remainder of this article.
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For instance:
If your compensation for your 1099 job were $23,000, you could contribute $23,000 as an employee contribution
(elective deferral) to your Solo 401(k).
Instead of calculating compensation, we'll provide you with the value.
On the other hand, if you opted for the SEP-IRA, you would be limited to just $5,750 as an employer contribution.
From this example, it's evident that the Solo 401(k) may allow for greater contribution capabilities for your side-gig compared to the SEP-IRA, thanks to the ability to make employee contributions. SEP-IRA also do not have catch-up contribution limits, which is an additional disadvantage.
But what about higher levels of compensation?
It's true that the SEP-IRA and Solo 401(k) might ultimately permit the same maximum contribution if the locum provider's compensation maxes out at $69,000 with only employer contributions. Essentially, if 25% of compensation equals $69,000 for 2024, there shouldn't be a difference between the two plans.
It's also possible that if one has a W-2 job alongside their locum tenens gig and maxes out employee contributions at the W-2 job's 401(k) plan, additional employee contributions aren't permitted in the Solo 401(k) plan. Only employer contributions would be allowed, essentially sharing the same limits as the SEP-IRA in this case.
So, should one still opt to open a SEP-IRA in these situations?
The Solo 401(k) may still hold an advantage.
The Solo 401(k) may help to avoid pro-rata rules when conducting backdoor Roth IRA conversions. This involves making non-deductible after-tax contributions to a Traditional IRA and subsequently converting the contribution to a Roth IRA because the modified adjusted gross income (MAGI) exceeds the limits allowing for direct contributions to the Roth IRA. If you convert the full amount, you shouldn't incur any additional tax, as you've already paid tax on the contributed amount.
The situation becomes complex from a tax standpoint if your Traditional IRA contains both pre-tax and non-deductible contributions.
If there are both pre-tax funds in your Traditional IRA and non-deductible contributions, you'll be subject to pro-rata rules, wherein any Roth IRA conversion may be taxed proportionally to the pre-tax amount in the Traditional Account, as this money hasn't been taxed yet.
To illustrate, imagine having $10,000 in your Traditional IRA as pre-taxed funds. This year, you intend to contribute $6,000 as a non-deductible contribution and proceed with the backdoor Roth IRA conversion. You can't simply convert the $6,000 without additional tax implications. Instead, the IRS calculates the proportion of after-tax funds in the account prior to conversion, with only that portion being considered already taxed, while the rest is deemed pre-tax dollars and thus taxable upon conversion.
Traditional IRA before contribution= $10,000
This year’s contribution non-deductible= $6000
% non-deductible contribution in Traditional IRA= $6000/$16000= 37.5%
Backdoor conversion after-tax amount= 37.5% * 6000= $2250 (this amount is not taxed after the backdoor Roth IRA conversion)
Backdoor Conversion pre-tax amount= 6000-2250= $3750 (You will pay tax on this amount after the backdoor Roth IRA conversion, since this has not been taxed yet)
As illustrated, you'll be taxed on a portion of the conversion. How does this relate to the SEP-IRA? The SEP-IRA is included in pro-rata calculations, essentially counting as part of the pre-tax Traditional IRA amounts when attempting backdoor Roth contributions.
This is where the Solo 401(k) may offer an additional advantage. Balances in the Solo 401(k) aren't factored into pro-rata calculations, ensuring clean backdoor Roth IRA conversions each year. If your objective is to have pre-tax retirement savings and conduct backdoor Roth IRA conversions, then the Solo 401(k) facilitates this strategy.
Finally, if you're considering combining a Defined Contribution Plan with a Defined Benefit Plan, such as a Cash Balance Plan, a SEP-IRA might not be the best choice. Depending on the SEP-IRA plan, a defined benefit plan may be disallowed, limiting your ability to contribute even more pre-tax dollars. In contrast, a Solo 401(k) can be paired with a Cash Balance Plan.
Tailored Solutions: At Modoo Strategy LLC, we specialize in assisting small businesses, including locum tenens doctors and travel nurses, navigate the complexities of retirement planning. Our team can evaluate your unique situation and recommend the most suitable retirement plans to optimize your tax savings and financial goals.
