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Solo 401(k) vs. SEP IRA: How Do You Choose if You're Self-Employed or a Small Business Owner?

Compare the pros and cons of solo 401(k) plans and SEP IRAs for self-employed individuals and small business owners who want to save for retirement.

As a self-employed individual, you don’t have access to a workplace benefits package like people who work for employers that offer plans such as 401(k)s, 403(b)s, 457s, or other options.

While you may be able to use a Roth IRA or a traditional IRA, these accounts have relatively small contribution limits.

Thankfully, you do have options as a self-employed business owner.

You can set up a workplace retirement plan of your own.

Two common options you may want to consider include solo 401(k) plans or simplified employee pension (SEP) IRAs.

Before you consider opening one or the other, you should understand how each works.

Here’s what you should know:

What is a Solo 401(k)?

A solo 401(k) plan is essentially a retirement plan a self-employed person can set up for themselves.

These plans are only for self-employed individuals that have no employees.

They often go by other names that indicate this, such as:

  • One-participant 401(k) plans
  • Solo-k
  • Uni-k
  • One participant k

Despite the one-participant rule, an exception does apply.

If only you and your spouse work within the business, you can still qualify. However, having any employees disqualifies you from using this account type.

These plans basically work the same as a regular 401(k) plan, except you have to set it up and manage it.

These plans allow two types of contributions.

The first type is called an employee deferral contribution.

These are contributions that come out of your self-employed pay.

The second are employer contributions.

These are allowed up to a specified limit and are an expense of your self-employed business.

Pros and Cons of a Solo 401(k)

Pros Cons
  • High contribution limits
  • Can be set up as traditional or Roth 401(k)
  • Can make employee and employer contributions
  • A spouse can also participate if they work in the business
  • Requires you to set up and maintain the plan
  • It cannot be used in a company with employees
  • Requires tax filing once plan assets exceed $250,000

Solo 401(k) contribution limits

Solo 401(k) contribution limits are broken down into two parts.

The employee deferral contribution limits are as follows.

In 2022, you can contribute up to $20,500 or up to 100% of your compensation. In this case, compensation is earned income.

If you’re age 50 or older, you get access to a catch-up contribution. This brings your total employee deferral contribution limit to $27,000 for 2022.

401(k)s also allow your employer, which is your business in this case, to make an employer contribution. These contributions are limited, as well.

As a self-employed person, you can contribute up to 25% of your net self-employment income. This is defined as your self-employment income minus half of your self-employment tax, as well as the contributions you made for yourself.

The IRS also imposes a total contribution limit of $61,000 for 2022 for people under age 50.

For people age 50 or older, this limit is $67,500 to account for the catch-up contribution option.

This total includes both employer and employee contributions.

Solo 401(k) deadlines

Contributions to a solo 401(k) plan must be made by the applicable deadlines.

Employee contributions must be made by December 31st of the year.

Employer contributions can be filed for the year until the tax filing deadline, including any extensions you may qualify for.

What is a SEP IRA?

A SEP IRA is an abbreviation for a simplified employee pension plan IRA.

While the title includes the word pension, you don’t actually get a pension out of this account.

Instead, you make defined contributions to the account each year.

Like a solo 401(k) plan, you must set up a SEP IRA for your business.

These accounts are only traditional in nature and do not offer a Roth option.

Technically, many businesses can have SEP IRAs. They only work ideally for business owners with no employees or very few employees, though.

There is a reason you don’t want to have many employees with a SEP IRA plan. These plans require you to contribute to both your own and your employees’ accounts at the same rate.

This can be costly if you’re trying to save as much money as possible in your account.

Pros and Cons of an SEP IRA

Pros Cons
  • High contribution limit
  • Relatively easy to set up and maintain as a business owner
  • You don't have to contribute every year
  • You don't have to contribute the same amount every year
  • Contributions give the business a tax deduction
  • Only employer contributions allowed
  • Contributions must be made to all employees equally
  • No Roth option available

SEP IRA contribution limits

Contributions are much easier to calculate for a SEP IRA.

Only employers can make contributions to this account type.

Some people call this a profit-sharing distribution.

The limit is the lesser of the two following amounts:

  • 25% of employee compensation
  • $61,000 for the year 2022

SEP IRA deadlines

The contribution deadline is typically the tax filing deadline for the tax year in question.

The deadline is April 15, 2023, for contributions to a SEP IRA for the 2022 tax year.

If your business files an extension, the deadline moves to your tax return’s extended deadline.

How to Choose Between a Solo 401(k) vs. SEP IRA

Choosing between a solo 401(k) and a SEP IRA requires understanding many factors.

After you understand these factors, you must apply them to your situation.

Here are some things to consider.

(You should also consult an expert before making a final decision.)

Number of employees

If you have any employees other than your spouse, a Solo 401(k) is not an option.

In this case, you can only choose a SEP IRA.

Even a SEP IRA may not be ideal if you have many employees.

This is because you must contribute to all employees’ plans at the same percentage as your own.

Desired account type

Both SEP IRA and solo 401(k)s offer traditional retirement accounts.

These allow you to make pre-tax contributions. Earnings grow tax-free.

Withdrawals are taxed at ordinary income tax rates in retirement.

Solo 401(k)s offer another option. This is called a Roth solo 401(k).

These allow you to make after-tax employee contributions. These contributions grow tax-free and can be withdrawn in retirement tax-free if you meet the guidelines.

Employer contributions are still made in a traditional Solo 401(k) account, though.

Catch-up contributions

People age 50 and older can make catch-up contributions to a solo 401(k) plan.

This offers an extra $6,500 in employee contributions.

Employees do not make contributions to a SEP IRA plan.

That means a catch-up contribution is not an option for SEP IRAs.

Ease of Maintenance

Once a solo 401(k) plan exceeds $250,000 in assets, you must file an annual tax return for the plan.

This requirement does not exist for SEP IRA plans.

When you establish the plan

In order to contribute to a Solo 401(k) for a year, you must establish the plan by the end of that year.

For instance, you must establish the plan by December 31st, 2022, to make 2022 contributions to the plan.

SEP IRAs are a little bit more forgiving.

These plans can be established by the tax deadline for the year and still receive contributions for that year.

For instance, you could open a SEP IRA on February 15th, 2023 and make contributions for the 2022 tax year.

Consult an Expert

For small business owners, deciding between a solo 401(k) vs. SEP IRA may seem overwhelming.

If you don’t understand the differences or want to deal with this complexity yourself, consul an expert.

Several types of experts are available to help you.

A Certified Public Account could recommend and help you set up these accounts in some cases.

A fiduciary fee-only financial advisor may be your best bet if you want a more complete overview of your personal and business finances.

These advisors do not take commissions as some other advisors may. Advisors who take commissions often have conflicts of interest due to the payments they receive.

By working with a fiduciary fee-only advisor, you pay a fee directly for the service you receive. These advisors look at your entire financial and retirement planning picture.

Then, they can suggest the best type of plan for your situation.

This could be a solo 401(k) or SEP IRA.

It may also be another type of retirement plan for businesses or self-employed people.

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