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SEP IRA vs. Solo 401(k): Which Is Better?

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When you’re self-employed, you’re in charge of choosing and funding your own retirement plan. In place of an employer-provided retirement plan like a 401(k), you may consider making contributions to a SEP IRA or solo 401(k) plan. But which one is the better option when it comes to saving money for your retirement? Here are the ins and outs of both SEP IRAs and solo 401(k)s, as well as the pros and cons of each. In the end, you’ll need to pick the right plan for your personal retirement strategy.

A financial advisor can help you create a retirement plan for your goals. 

What Is a SEP IRA?

A SEP IRA or Simplified Employee Pension is a type of individual retirement account that’s designed for small business owners and the self-employed. These plans can be set up by a small business for itself and its employees if there are any. With this type of plan, only the employer makes contributions; employees don’t add any of their own money. However, employees are always 100% vested in their accounts at all times.

You can make contributions to a SEP IRA as a self-employed person no matter the size of your business or your business structure. That means you can use one of these accounts for retirement savings whether you have a sole proprietorship, limited liability company or corporation.

For 2023, the maximum amount employers can contribute to a SEP IRA is the lesser of 25% of the employee’s compensation or $69,000 ($66,000 in 2023). There are no catch-up contributions associated with a SEP IRA.

Contribution limits for self-employed individuals work a little differently. Contributions are limited to 25% of your net earnings from self-employment, up to the annual limit.

In terms of how SEP IRAs are taxed, they follow the same rules as traditional IRAs. Contributions are tax-deductible, and for self-employed individuals, the IRS has a special formula that determines what amount you can deduct, based on your self-employment earnings.

Qualified withdrawals are taxed at your ordinary income tax rate in retirement. At age 70.5, you must begin taking required minimum distributions, based on your account balance and life expectancy.

What Is a Solo 401(k)?

SmartAsset: SEP IRA vs. Solo 401(k)

A solo or individual 401(k) plan is a 401(k) retirement account that’s designed for sole proprietors and small business owners whose only employee is their spouse. With this type of 401(k), the account owner can make contributions both as the employer and employee.

For 2024, the amount you can contribute as an elective salary deferral is 100% of compensation up to the annual limit of $23,000. That number stood at $22,500 in 2023. An additional $7,500 catch-up contribution is allowed for self-employed workers age 50 or older in 2023 or 2024.

The amount you can make for nonelective employer contributions is based on your net earnings from self-employment after deducting one-half of your self-employment tax and contributions for yourself. Altogether, total contributions, not counting catch-up contributions, are limited to $69,000 for 2024 and $66,000 for 2023.

For tax purposes, a solo 401(k) is treated the same as a traditional 401(k), unless it’s designated as a Roth account. Under traditional 401(k) rules, your qualified withdrawals are taxed at your ordinary income tax rate. A 10% early withdrawal penalty and ordinary income tax would apply to non-qualified withdrawals. Required minimum distributions would kick in beginning at age 70.5.

A Roth solo 401(k) would follow Roth IRA tax rules. That means no deduction for contributions, but qualified withdrawals would be tax-free. There are also no required minimum distributions to worry about.

SEP IRA Pros and Cons

On the pro side, opening a SEP IRA for yourself (and your employees if you have them) is generally an easier process than setting up a solo 401(k). It’s similar to opening a traditional or Roth IRA, and the level of maintenance required for your annual tax filing is also simpler. Contributions you make on behalf of employees can be written off as a tax deduction, along with contributions you make to your own SEP IRA.

It’s also important to note that self-employed individuals interested in opening a SEP IRA can do so up to the income tax deadline for the tax year in which they want to contribute.

The biggest drawbacks for self-employed workers with a SEP IRA center on taxation and withdrawals. A SEP IRA must follow traditional IRA tax rules – there is no Roth option. That means if you make withdrawals prior to age 59.5, you’ll be subject to the 10% early withdrawal penalty unless an exception applies. Your options for getting around the penalty are limited because SEP IRA plans don’t allow for loans.

Solo 401(k) Pros and Cons

The main advantages offered by a solo 401(k) include the Roth option and being able to take loans from your account, the way you could with an employer’s 401(k). You could borrow up to 50% of your plan’s value or $50,000, whichever is less. That could be helpful if you need money for a large purchase, such as buying a piece of business equipment. The catch, however, is that if you don’t repay the loan, it becomes a taxable distribution. Not to mention you’ll miss out on compound interest that could have accrued on the money had you left it in your plan.

Cost and setup are other cons to keep in mind. A solo 401(k) is generally more difficult to start since there’s more paperwork involved. You may also pay higher maintenance fees to keep the plan open compared to a SEP IRA.

Self-employed individuals looking to open a solo 401(k) can only open one by the end of the calendar year, December 31. However, they can make contributions for the tax year up until the tax deadline for that tax year.

Bottom Line

SmartAsset: SEP IRA vs. Solo 401(k)

Both SEP IRAs and solo 401(k)s can help you sock away money for your later years when you run your own business. Your age, self-employment earnings and business structure may determine which one is best for your retirement goals. Consider the costs and ongoing responsibilities to maintain your account, as well as what you can put into the account as a self-employed business owner. With a little research, you’ll find the right retirement plan for your current and future financial situation.

Tips for Self-Employed Retirement Planning

  • financial advisor could help you create a retirement plan for your needs and goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • If you haven’t done so yet, use a retirement calculator to determine how much money you’ll need to save. Then, compare that to what you’ve saved already. Calculate how much money you’ll need to put away yearly and monthly from your self-employment income to reach your goal.
  • Consider how you can supplement your retirement savings, too. If you have a high-deductible health plan, for instance, you may be able to save money on a tax-advantaged basis in a Health Savings Account.

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