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. 

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