Solo 401(k) vs. SEP IRA: Which One Should I Choose?

As a self-employed individual or business owner you have a few different ways to save for your retirement. The primary retirement savings plan option for self-employed individuals are Solo 401(k)s, and for small business owners are SEP IRAs, but that does not mean you are required to use one over the other. In some cases, a SEP IRA may make the most sense for a self-employed individual, while a Solo 401(k) may be the best option for a small business owner who meets the requirements. While these two options have many similarities, understanding the differences can have a significant impact on the amount you are able to save towards retirement.

Solo 401(k)

A Solo 401(k), also known as an Individual 401(k), is a qualified retirement plan for business owners who have no full-time employees, other than a spouse that also is employed by the business. Both Traditional (pre-tax) and Roth options are available.

As both the business owner and employee, you are eligible to make contributions both as an employee and as the employer. Employee contributions can be made up to the current annual contribution limit ($22,500 in 2023, plus $7,500 if you are over age 50). Contributions can be made up to 100% of compensation, however, the maximum amount of compensation that can be used to calculate contribution limits is $330,000 in 2023

Employer contributions cannot exceed 25% of the employee’s net compensation. Total contributions from all sources (employee + employer) cannot exceed $66,000 for 2023 if you are under age 50, and $73,500 if you are age 50 or older. The additional allowable contributions after age 50 are called “catch-up contributions.”

Solo 401(k)s do not have age or income restrictions for eligibility. These plans must be established, and employee contributions made by the end of the calendar year. Employer contributions can be made up to the tax filing deadline, including extensions. There are no filing requirements until the plan balance reaches $250,000.

See example in the section “Case Study”

SEP IRA

A Simplified Employee Pension (“SEP”) IRA is a type of retirement plan that is primarily used by small business owners or self-employed individuals, although they are available to any size business. SEP IRAs are relatively simple to establish and maintain. As of 2023, Roth options are now also available with SEP IRAs.

Unlike Solo 401(k)s, SEP IRAs are funded through employer contributions only. Contributions do not need to be made every year, but when made, each eligible employee must receive a contribution that is an equal percentage of compensation as the owner makes to his or her own plan. In the case of a self-employed individual, that person would be the sole employee. The business would make contributions for the owner, up to the maximum allowable amount each year. Contributions are tax-deductible to the business.

For small businesses, contribution limits for SEP IRAs are limited to the lesser of 25% of the employee’s compensation, or $66,000 (in 2023). For self-employed individuals, the limit is 25% of adjusted net self-employment earning. The maximum compensation that can be used to calculate the 25% limit is $330,000 in 2023. Catch-up contributions are not allowed to SEP IRAs.

SEP IRAs do have eligibility requirements, which apply not only to employees of a small business, but also to self-employed individuals. An employee is considered to be eligible if he or she is over age 21, has worked for the business in at least 3 of the past 5 years, and has earned a minimum of $750 in compensation for the year. The employer may choose to use less restrictive eligibility requirements, but not more restrictive. These plans can be established, and contributions made for a given year at any point prior to the business’s tax-filing deadline, including extensions.

See example in the section “Case Study”

Which One Should I Choose?

When determining which option is right for you, there are multiple variables to consider. Some of the questions to think about are:

• Do you have employees, or do you expect to hire employees in the future?
• Does your business consistently generate enough revenue for you to make employer contributions for yourself as well as your employees, or would you require more flexibility?
• How concerned are you about the expenses associated with setting up and maintaining a retirement plan?

Case Studies

1) Self-Employed Consultant

• Following a corporate career, an individual sets up her own consulting business.
• Individual is age 60, single, and net business income is $100,000 per year.
• The consulting business income is not needed for living expenses, due to other income sources.
• The goal is to maximize pre-tax savings for the consulting income.

In this case the Solo 401(k) would allow for $20,733.75 more in pre-tax savings (or 68% more in pre-tax savings) due to the allowed employee contribution.⁴

2) Business Owner

• A small business owner employs only himself may hire 1-2 additional employees in the next year or two because the business has continued to grow and be profitable.
• The owner is 45 years old and takes a salary of $200,000 per year.
• His goal is to maximize his pre-tax savings each year. He would like to contribute for his employees once he hires them as well and wants a plan that’s inexpensive and easy to maintain.

In this case, although the Solo 401(k) would allow $13,927 more in contributions⁸, that option will not be available to the business owner when he hires additional employees; he would need to set up a standard 401(k) plan which would require additional expense and maintenance. Since one of his goals is to set up a plan that’s easy to maintain and is inexpensive, in addition to a desire to contribute to his future employees’ plans, he may want to consider the SEP IRA as a better option.

Summary

Which retirement savings plan is best for you will be highly dependent on your unique situation. In some cases, factors other than potential contribution amounts will need to be considered and may impact the final decision, as we saw with the second case study above. Your Freestone Client Advisor, in conjunction with your tax professional, can help you make the best choice for your circumstances.

Important Disclosures: Nothing in this document is intended to provide, and you should not rely upon it for, accounting, legal, tax, retirement or investment advice or recommendations. We are not making any specific recommendations regarding any retirement savings strategies, and you should not make any retirement savings plan decisions based on the information in this document. The intention of this document is educational, and it is intended only to discuss limited aspects of retirement savings plans in general terms. This document is not a comprehensive or complete summary of considerations regarding retirement savings plans. Each individual is in a different situation and has different items to address, and the options in this document are not appropriate for everyone. Please consult your Freestone client advisor regarding options specific to your needs.