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

SEP IRAs and solo 401(k)s are tax-deferred retirement savings vehicles for small business owners. They’re similar to each other but with one big difference. With a solo 401(k), a self-employed business owner can make contributions as both the employee and the employer. Let’s break down what you need to know when choosing between a SEP IRA and solo 401(k).

If you don’t know where to begin when setting up your retirement plan, you may want to speak with a financial advisor.

What Is a SEP IRA?

If you run your own business and have a small number of employees, you may be interested in a Simplified Employee Pension (SEP) plan or SEP IRA. It allows you to contribute toward your retirement savings while doing the same for your employees.

A SEP functions similarly to a traditional IRA. This means your contributions are tax deductible and your money grows tax-free. The IRS taxes your distributions when you make qualified withdrawals in retirement. However, you enjoy some perks you won’t get with a traditional IRA.

For starters, you may enjoy much larger contribution limits. You can contribute the lesser of the following in 2023:

25% of your compensation
$66,000 (up from $61,000 in 2022)

Meanwhile, a traditional IRA permits contributions up to $6,500 or $7,500 if you’re at least age 50.

That said, if you contribute to a SEP IRA for yourself, the IRS requires that you also contribute toward the SEP IRA of every eligible employee. What’s more, those employer contributions much match the percentage of compensation you contribute toward your own. So if you contribute 20% of your compensation toward your own SEP IRA, you must also contribute 20% of each eligible employee’s compensation to his or her individual plan.

Eligible employees, as far as the IRS is concerned, are those that meet the following criteria:

They’re at least 21 years old
They’ve worked for you during three of the last five years
They’ve earned at least $750 from you in the past year

How Does a SEP IRA Work?

A SEP IRA has many of the same features as an IRA. You can open one through most financial institutions or banks that offer traditional IRAs. Most providers offer access to an array of funds with which you can build your SEP IRA portfolio. You can construct one with various investment options including the following:

Stocks
Bonds
Target-date funds
Mutual funds
Exchange-traded funds (ETFs)

SEP IRA: Pros and Cons

In addition to having high contribution limits, a SEP IRA allows you to deduct all your employer contributions when calculating your business taxes. Also, there is no rule stopping you from making additional contributions to a traditional IRA or Roth IRA for yourself, though the amount you can claim as tax-deductible may be limited.

As far as cons go, the SEP IRA has many of the same restrictions as IRAs. If you withdraw money from your account before turning 59.5 years old, the distribution would be taxed as ordinary income plus a 10% early withdrawal penalty. In addition, you must begin taking required minimum distributions (RMDs) when you turn 72 (age 73 if you reached 72 after December 31, 2022). This ensures that the government starts receiving taxes on your savings.

Plus, the fact that you must contribute toward each employee’s plan can make this a particularly expensive choice. So a SEP IRA perhaps is best for small-business owners with a small pool of employees. Automatic contributions toward your employees’ plans can be a major selling point to attract the right talent.

Employees can’t contribute to their own SEP IRAs in most cases. But they’re also allowed to open their own traditional or Roth IRAs. But if this proves to be more expensive than beneficial, you can set up a solo or individual 401(k) plan for your business.

What Is a Solo 401(k)?

A solo 401(k) or sole-participant 401(k) is a retirement plan designed for the self-employed who can sock away more than traditional or Roth IRA limits. You can open one only if you and your spouse are the only employees in your business.

A solo 401(k) functions much like its corporate counterpart. If you have a solo 401(k), you fund it on a pre-tax basis and your investments grow tax-free. Or you can opt for the Roth solo 401(k). You fund it with after-tax dollars, so it won’t reduce your taxable income. But your earnings are tax-free when you make qualified withdrawals.

In 2023, as an employee, you can contribute up to $22,500 to your solo 401(k), and an additional $7,500 if you are at least age 50. These are the same limits corporate 401(k) plans have.

As with a corporate 401(k), you, as an employer, can also contribute to your solo 401(k). This is to tune of up to 25% of your compensation. The IRS defines this as your net earnings from self employment minus one half of your self employment tax and the contributions you made to your plan as an employee. However, only up to $330,000 worth of compensation can get calculated into your employer contribution limit.

That said, total contributions (employer and employee, combined) to your solo 401(k) can’t exceed $66,000, or $73,500 if you’re at least 50 years old in 2023.

To calculate your contribution limits and allowable tax deductions accurately, you can use the worksheet on IRS Publication 560. Look under “Retirement Plans for Small Businesses.”

Pros and Cons of a Solo 401(k)

A solo 401(k) is a great option for a self-employed individual with no employees who can afford to save more than $6,500 a year, the traditional IRA limit in 2023. Not only can you make bigger contributions as an employee, but you can also make contributions as an employer.

What’s more, you can double that amount if your spouse also earns income from your business.

You should note, however, that a solo 401(k) may involve a little more paperwork. You’ll need to file an annual IRS Form 5500 to report the plan’s assets and ensure it stays in compliance.

Furthermore, Solo 401(k) plans have strict contribution deadlines. Before 2022, you could only open one by the end of the calendar year on December 31. But the Secure 2.0 Act extended the deadline for you to establish a plan after the taxable year ends, but before your tax filing deadline, which is usually in April of the following year.

How Do I Open a Solo 401(k)?

You can open a solo 401(k) through most financial institutions and online brokers. You just need your employer identification number to apply. You’d most likely need to sign a plan adoption agreement and fill out an application.

Moving forward, a solo 401(k) works like most retirement plans. You can build a diversified portfolio with a variety of funds like stocks, bonds and mutual funds. But you must fill out IRS form 5500-SF if your plan has more than $250,000.

Bottom Line

If you’re deciding between a solo 401(k) and a SEP IRA, and you have employees, the choice is easy: SEP IRA. You can’t open a solo 401(k) plan if you have an employee other than your spouse.

But if you’re self-employed with no employees, the choice depends on how much you plan to save. If you can’t put away more than $6,000, you should go with the SEP IRA until you can afford to save more. If you don’t want to defer taxes, you may want to open a solo Roth 401(k) or a Roth IRA, depending on how much you can save.

Retirement Planning Tips

If you’re in business for yourself, a financial advisor can help you with retirement planning. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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