SEP IRA vs. Solo 401(k) – Which Is Better for You?

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Introduction to Self-Employment Retirement Plans

Self-employment has many perks. But it also comes with a lot of responsibilities — not the least of which is saving for your own retirement. When you work for an employer, you can usually count on there being a 401(k) plan or something similar already in place that you can contribute to. However, when you work for yourself, it's a different story. Since you are your own boss, you are responsible for both starting your own plan and funding it.

Luckily, there are products on the market that can help you out. Here are two retirement plan options worth considering if you're self-employed or a business owner.

What Is SEP IRA?

A simplified employee plan (SEP) IRA is a type of IRA that works well for the self-employed or the small business owner. If you have employees, they can make contributions. But this can be an expensive proposition since contributions for employees must match the percentage of the salary that the owner makes for themselves. So if you've got employees, another plan such as a 401(k) or a Simple IRA might be a better choice. (If you're interested in setting up a 401(k) plan for your employees, check out services such as America's Best 401k, which can help you provide your employees with quality, low-cost plan.)

Some features of the SEP IRA include:

  • Contributions are made entirely by the business. There are no employee contributions.
  • Contributions are a business expense.
  • Contributions can be made up to 25% of compensation. For those who are sole proprietors, this might actually end up as 20% of self-employment income due to the way the calculation flows through Schedule C.
  • The maximum contribution for calendar year 2020 is $57,000.
  • SEP IRA accounts are available through most major custodians.
  • Investment choices are generally the same as for a regular IRA account.
  • A SEP IRA account can be opened and funded up until the date your tax return is filed, including extensions for the prior year.

However, you might want to take note of these limitations:

  • There are no loans available from a SEP IRA.
  • There is no Roth option available.

What Is Solo 401(k)?

A solo 401(k), also called an “individual 401(k),” is a great solution for the self-employed as well. The solo 401(k) offers both employee and employer contributions. Most major custodians offer a solo 401(k). However, the rules may differ a bit from custodian to custodian.

Some features of the solo 401(k):

  • The plan is available only to business owners, spouses involved in the business, and partners. Other employees are not allowed to participate.
  • Employee salary deferrals are allowed, as well as employer profit-sharing contributions.
  • The limits for employee deferrals are the same as for a 401(k) plan offered by an employer. The limit is $19,500 annually with a $6,500 catchup for those who are 50 or over at any point during the year.
  • The maximum combined employee contributions plus employer profit-sharing contributions cannot exceed $57,000 for 2020, with an extra $6,500 up to $63,500 for those who are 50 or over during the year.
  • Most major custodians support solo 401(k)s. Investment options are generally the same as available to other investors in brokerage or IRA accounts. However, some custodians may have restrictions. So it is the best check before opening your account.
  • In order to take a deduction for the current tax year, the account must be opened by Dec. 31 of that year.
  • Both salary deferral and employer profit sharing contributions can generally be made until the date your return is filed, including extensions. This can vary for the salary deferral based on your business’s structure. It's best to check with a knowledgeable tax professional here.
  • Loans and a Roth option are permitted. But you should check the rules for the plan offered by your custodian to confirm this.
  • There are minimal governmental filing requirements that generally don’t kick in until the plan balance exceeds $285,000.

So Which Plan Is Best for You?

While there are some similarities, there are some differences too. And as with most things in the world of investing, there's not a one-size-fits-all solution.

The SEP IRA will be the easiest to open. A plan can be started up to the date that your return for the prior year is filed, including extensions. However, while the solo 401(k) might involve a bit more paperwork to open, the difference here is small.

There's a bigger difference that's worth taking into consideration.

In years when your income may be lower than usual, the “percentage of compensation” method used for calculating SEP IRA contributions will result in a lower contribution amount for you even if you have the cash to make a larger contribution. In addition, the SEP IRA doesn't allow for catch-up contributions.

With a solo 401(k), as long as your compensation exceeds the $19,500/$26,000 annual limits, you can contribute the full amount. So if you're really looking to save for your retirement big-time, a solo 401(k) might be your best bet.

Conclusion

When you're self-employed, it can be easy to overlook investing in a retirement plan. (After all, you don't have an HR department sending you reminder emails about signing up for an employer-sponsored program.) But there's no reason why you can't be saving too. No matter which plans you choose — whether it's a solo 401(k) or SEP IRA or another kind of retirement savings program — make sure to do your due diligence. Talk with a trusted financial expert (wealth management firm choosing a custodian.

Roger Wohlner

Roger Wohlner is an experienced financial advisor, finance blogger and freelance writer based in Arlington Heights, Ill. His expertise includes providing financial planning and investment advice to individual clients, 401(k) plan sponsors, foundations and endowments. Roger contributes to his own popular finance blog, The Chicago Financial Planner, where he writes about issues concerning financial planning, investments and retirement plans. His work has been featured on Investopedia, Go Banking Rates, US News & World Report, Yahoo! Finance, Equifax Finance Blog and other publications. You can follow Roger on: Twitter - LinkedIn

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11 Comments

  1. Sorry this article is confusing with lacks of specifics!. If as a business owner with one employee., I contribute 20% to a SEP IRA ( Not clear to me if it based on my net business income…. or my own wages if any)
    If Based on wages does that employee also has to contribute the 20% out of his/her wages or the employer as to match that 20% based on the employee wages?
    If it comes out the employee wages what if he/she does not want to participate?
    Can I still set up my own?

  2. Thanks for the article. The IRS website says that employer nonelective contributions are up to 25% of compensation as defined by the plan (similar to SEP-IRA). However, this article only mentions the maximum combined employee contributions. Could you (or anyone) confirm that the employer contributions are the same for both the SEP and the solo 401k? Thank you.

  3. I have 2 different companies. Can I have a SEP with company #1 and keep the i401k with company #2? I am asking because I already have a SEP with Fidelity and they will not let me open a i401k during the same year, so I was thinking of doing the i401k with a different company. Thanks!!

  4. For most high income earners, I typically recommend going with the Solo 401k simply because it leaves the Backdoor Roth open. If you have a SEP, it really muddies up the waters if you’re trying to go down that route.

    It definitely takes a little bit more work to set up a Solo 401k, but honestly not that much. If you have funds in a SEP-IRA, its easy enough to just transfer them over to a Solo 401k later down the line.

    1. Thanks for the comment and I concur. A Solo 401(k) is typically fairly easy to establish at most custodians.

  5. This is a good summary. Readers should also be aware that particular providers might impose greater restrictions than the limitations “even one employee (other than your spouse) that works more than 1,000 hours in a year;” Vanguard, for instance, restricts Solo 401(k) plans to companies that have NO common-law employees, so even a part-time employee who works a few hours a year would void the plan.

    A company that finds itself hiring an employee under such circumstances may have the option of switching from the Solo 401(k) to a SEP, but there are also IRS restrictions on having more than one qualified plan in the same tax year, so I think such a switch would have to coincide with the end of the year.

  6. Overall very good article and easy to understand. One comment though: Where is says “…using the 25% of earnings as a guide. Your total contribution is capped at 100% of your net earnings, or $50,000…” Is the “100%” extra in the sentence above? I thought it was 25% of net earnings up to a maximum of $50,000 for 2012.

  7. The SEP IRA is often overlooked when considering investment options for businesses. Thank you for pointing it out. I wasn’t aware that you were allowed large contributions to the SEP . . . great info!

  8. Good post, this is important stuff for anyone who is self-employeed or who owns a small business. A few additional points:

    1. The solo 401(k) can also be established with a Roth option, this will vary by provider/custodian.
    2. The solo 401(k) allows for an additional catch-up contribution of $5,500 for people who will be 50 or over in 2012, there is no catch-up for the SEP.
    3. If you have employees and use a SEP this can get quite expensive in a hurry.

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