SEP vs Solo 401(k): What Plan is a Better Choice

SEP vs Solo 401(k): What Plan is a Better Choice

Published on July 13, 2021

Working for yourself doesn’t mean you have to miss out on the tax benefits that regular employees get from standard workplace retirement plans. If you’re self-employed and looking for a retirement plan, you may be trying to decide between a solo 401(k) and a SEP IRA. With both retirement plans, your investment in your tax-favored retirement:

  • creates tax deductions for the money you invest in the plan,
  • grows tax-deferred inside the plan, and
  • is subject to tax only when you take the money from the plan.

What Is a SEP IRA?

Congress created the Simplified Employee Pension Individual Retirement Account (SEP IRA) in 1978 to extend the IRA concept to small businesses. The term pension in this case is a bit archaic—a SEP IRA is not a defined benefit plan. Rather, it lets the self-employed and small businesses and their employees benefit from simple, tax-advantaged retirement savings accounts similar to personal individual retirement accounts (IRAs).

SEP IRAs are available from most major brokerage firms and easy to set up. Unlike a traditional 401(k) plan, SEP IRAs have little to no administrative overhead. Companies with only a single employee can take advantage of SEP IRAs, meaning they can be a good choice for solo entrepreneurs or gig workers.

Most importantly, SEP IRAs offer more generous tax breaks than personal IRAs. In some cases, the tax deduction for a SEP IRA can be nearly 10 times that of an IRA.

SEP IRA Eligibility and Contribution Limits

Any business with one or more employees is eligible for a SEP IRA, including freelance workers and independent contractors. 

There’s one key feature of SEP IRAs that differentiates them from Solo 401(k)s: Only the employer can make contributions to a SEP IRA account. Employees are not permitted to make their own elective contributions, although a solo entrepreneur or self-employed person — who is in effect both employer and employee — may contribute acting as employer.

The maximum SEP IRA contribution is the lesser of 25% of adjusted net earnings or $58,000 for 2021. Accounting for exemptions, this works out to be about 20% of earnings for self-employed individuals, as calculated using IRS Publication 560. That means a self-employed person under 50 with an annual net profit of $100,000 could contribute a total of $18,587 to an SEP IRA. Since employee contributions are not allowed, SEP IRAs do not allow catch-up contributions for people 50 or older.

Funds paid into the SEP IRA are fully tax deductible up to the IRS limits, giving the business or self-employed person a dollar-for-dollar reduction in taxable income. For side-hustle workers who don’t pay withholding taxes and worry about their end-of-year tax bill, the deduction can really help.

What Is a Solo 401(k)?

A Solo 401(k) is essentially a 401(k) plan designed for individuals. The plan may also be referred to as an individual 401(k) or a one-participant 401(k).

This tax-advantaged retirement plan is generally limited to just self-employed individuals, though spouses who work at least part time for them may be eligible to contribute to one as well. If you ran a small business with only one other employee who was not your spouse, then, you would not be eligible to save for retirement in a Solo 401(k).

For self-employed people, however, a Solo 401(k) may offer greater annual contributions and bigger tax deductions than a SEP IRA, depending on your income. Solo 401(k) plans also allow you to make post-tax Roth contributions.

Solo 401(k) Eligibility and Contribution Limits

The Solo 401(k) annual contribution maximum is $58,000 in 2021. Unlike SEP IRAs, people aged 50 and older can make additional catch-up contributions of $6,500 a year to a Solo 401(k), bringing the potential total to $64,500 in 2021.

Here’s the tricky part: Since the Solo 401(k) owner acts as both employer and employee, both types of contributions can be made—and that means most workers can contribute more and receive a higher tax break. That’s because as employees they can contribute up to $19,500, but as employers they can add onto that up to 25% of their adjusted income for a maximum total contribution of $58,000 in 2021.

In the $100,000 example above, our hypothetical under-50 worker with $100,000 in annual net profit could make a total contribution of up to $38,087. Of that total contribution, $19,500 would be the salary deferral as an employee while $18,587 would be a profit sharing contribution as an employer. If the same worker were 50 or older, they could add $6,500 to that total.

Eligibility requirements are fairly straightforward: Anyone who generates net profits from a sole proprietorship, LLC or other business organization can open a solo 401(k) as long as they have no employees aside from their spouse.

Solo 401(k) vs SEP IRA

Both a solo 401(k) and a SEP IRA can supercharge retirement savings for self-employed people. 

If you have no employees, and are deciding between SEP IRA and solo 401(k), consider the following:

  • SEP IRA is easier to set up and cheaper to administer than solo 401(k)
  • Solo 401(k) has one filing requirement, Form 5500, once your retirement account reaches $250,000 in assets. SEP does not have a requirement to file Form 5500
  • Solo 401(k) will typically allow you to contribute more into your retirement account per year, which will also result in a higher tax deduction

As always, you should first consult with your tax professional and financial advisor before making a decision.

If you are interested to learn more about ways you can increase your tax deductions and lower your tax, use this link to schedule a call with one of our team members. 

If you wish to subscribe to our newsletter “MyCashZone” to receive tax tips and financial advice directly to your inbox, please use this link to sign up. 

Return to Blog

Read other blog posts

Moving to a Lower Tax State

Published on July 19, 2021
Are You Thinking about Moving to a Different State? Is Your State Tax Part of Your Decision-Making?   If your intent is to relocate to a lower-tax state, it may seem like a no-brainer to move to one that has no personal income tax. No! To avoid an expensive misstep, you must consider all taxes that […]
Moving to a Lower Tax State

Paypal Changes You Should Know About

Published on July 07, 2021
If you’re selling stuff online and using payment processing services, like PayPal or eBay, to collect money, get ready for upcoming changes. The IRS now wants to know if your Paypal or Ebay sales exceed $600 a year.  Starting 2022, the federal threshold for issuing 1099-K will drop to $600 with no minimum transaction level, […]
Paypal Changes You Should Know About

Should I Make An S Corporation Election?

Published on June 24, 2021
Choosing the right business type is important to the success of your business. The business structure you choose influences everything from day-to-day operations, to taxes, to your ability to raise money, and to how much of your personal assets are at risk.   Whether you are just starting your business, or have been operating as a […]
Should I Make An S Corporation Election?

Create Tax Deductions on Your Vacation Home

Published on June 09, 2021
Do you own a vacation home? If yes, did you know that you might be able to deduct a number of vacation home expenses on your business tax return?  Business-Lodging Exemption If your business uses your vacation home or condo exclusively for business lodging purposes, you elude the vacation-home rules and allow you to deduct […]
Create Tax Deductions on Your Vacation Home

2021 Self-Employment Tax Planning

Published on June 03, 2021
If you are self-employed, I am sure you were surprised by your federal tax bill at least once during your self-employment career! I cannot tell you how many times I had to explain to my new self-employed clients why they had a huge federal tax bill even though net profit from the business was modest. […]
2021 Self-Employment Tax Planning

How to Deduct 100% of Your Business Meal

Published on May 26, 2021
Did you know that you can now deduct 100% of the meals incurred for business purposes?  In an effort to assist this industry, the Consolidated Appropriations Act of 2021 introduced a 100% business meal deduction. This temporarily increases the deduction of expenses that are paid or incurred for food or beverages provided by a restaurant […]
How to Deduct 100% of Your Business Meal

How Will The New Stimulus Bill Affect You!

Published on December 23, 2020
Finally “Coronabus”, the Coronavirus Relief & Omnibus Agreement, has been passed by Congress! This massive 5,600-page bill was highly anticipated by millions of individual Americans and small businesses! It has not been signed into law yet but it is very close! This $900 billion legislation has something for every business: PPP PPP2 EIDL Grants Tax […]
How Will The New Stimulus Bill Affect You!

Say What? 60% Tax Rate?

Published on December 22, 2020
Did you know that Biden’s tax plan would put some taxpayers in a combined marginal rate in excess of 60%? Check out the table below. Taxpayers in California, Hawaii, New Jersey and New York City are out of luck! Table obtained from Check out Table 2 included in the Tax Foundation article Top Rates […]
Say What? 60% Tax Rate?

Case Study: How We Increased Client’s Bank Balance by $24,485 a Month

Published on November 04, 2020
Mandy Marketing LLC is a fast growing marketing agency located in Massachusetts. The company is in business for only two years but is on the way to reach $850K in gross sales by the end of 2020. It has two founders and 4-5 contractors who work variable hours depending on how many projects are ongoing. […]
Case Study: How We Increased Client’s Bank Balance by $24,485 a Month

3 Secrets of Tax Planning for Marketing and Digital Agencies

Published on November 03, 2020
Last week at a socially-distanced birthday party I met Matt, who turned out to be the owner of a small digital agency in NJ. When Matt found out that I own a CPA firm specializing in tax planning and CFO services for advertising and digital agencies, he started bombarding me with questions. I gave Matt […]
3 Secrets of Tax Planning for Marketing and Digital Agencies