Solo 401k vs SEP IRA

When it comes to saving for retirement, small business owners, freelancers, and consultants have several options to choose from. While traditional 401(k)s and IRAs are an option, most business owners are interested in a tax-advantaged retirement plan that allows them to soak away larger amounts of money for their retirement. Both SEP IRA and Solo 401(k) were introduced to provide a simple way for small business owners to plan for retirement, without the complexities associated with ERISA-sponsored plans.

When comparing Solo 401(k) vs. SEP IRA, you should determine the most favorable option for your business. If the business has employees, you should consider opening a SEP IRA since it allows you to set up multiple accounts for employees. It is easy to open, and you can set up a SEP IRA account online. If you are a solo entrepreneur with no employees, you should consider opening a Solo 401(k) to enjoy bigger tax deductions and higher contributions.

What is SEP IRA?

SEP stands for Simplified Employee Pension, and it was created in 1978 to provide a form of retirement planning for small businesses. It allows business owners to benefit from a tax-advantaged savings account that operates in the same way as a personal individual retirement account (IRA).

A SEP IRA is funded with employer contributions only, and employees are not allowed to contribute directly to the account. If a small business has other employees apart from the owner and the spouse, the business owner must contribute a similar percentage to the employee’s account as they do their own. Hence, a SEP IRA can be an expensive option for businesses with employees, since the business owner will have to contribute to every employee’s account. SEP IRAs are ideal for solo entrepreneurs or businesses with no employees.

SEP IRA Eligibility and Contribution Limits

A SEP IRA is available for small businesses with one or more employees, including independent contractors, sole proprietorship, C corporations, and S corporations. Since only employers are allowed to contribute to the account, a solo entrepreneur may contribute as an employer.

You can contribute up to 25% of your adjusted net earnings, up to a maximum limit of $58,000 for 2021 ($57,000 for 2020). All the contributions made to a SEP IRA are tax-deductible, and business owners get a reduction in their taxable income.

What is Solo 401(k)?

Also known as one participant 401(k), a Solo 401(k) is a retirement plan that is available to the business owners and spouses involved in the business. It provides business owners with benefits that are available in a typical 401(k) plan such as tax-deferred growth, tax breaks, and a Roth option. Unlike a SEP IRA, a Solo 401(k) allows bigger annual contributions and tax deductions, depending on your income. Also, the contribution is not limited to the percentage of your income.

Solo 401(k) Eligibility and Contribution Limit

A Solo 401(k) is available to businesses that generate revenue from a sole proprietorship, LLC, or other types of business organizations that are run by the business owner and their spouse(s).

The annual employee contribution limit is $19,500 in 2021. If you are above 50, you can make catch-up contributions of $6,500 per year, bringing the total contributions to $26, 000 in 2021. Additionally, the business owner can make profit-sharing contributions of up to 25% of their adjusted income. This brings the maximum total contribution in 2021 to $58,000 ($64,500 for above age 50).

Key Differences between SEP-IRA and Solo 401(k)

Both SEP IRA and Solo 401(k) allow business owners to contribute part of their revenue as retirement savings. However, these retirement plans differ in the following ways:

Contribution Rate

A SEP IRA is percentage-based, and it limits employer contribution to 25% of the business owner’s income. In contrast, a Solo 401(k) allows the business owner to contribute both as an employee and employee. As an employee, a business owner can contribute up to the IRS limit of $19,500 in 2021, and catch up of contributions of $6,500 for those age 50 or older. Additionally, as an employer, the business owner can contribute up to 25% of their income.

Roth Options

If you looking to benefit from tax-free growth of your retirement savings, you could consider a retirement plan with a Roth option. Your best bet is a Solo 401(k), which allows business owners to contribute on an after-tax and pre-tax basis. With the Roth option, your money will grow tax-free, and you will not owe income taxes when you take a distribution in retirement. In contrast, a SEP IRA does not provide a Roth option; business owners are restricted to pre-tax contributions, and they will owe taxes when they take a distribution in the future.

Business with Employees

If your business has other employees apart from you and your spouse, you could consider a SEP IRA. A SEP IRA allows the business to set up retirement accounts for multiple employees, and the employer will be required to contribute a similar percentage for all employees. In contrast, a Solo 401(k) is not available to businesses with employees, and you can only set it up if it is only you and your spouse involved in the business.

Which Should You Choose: SEP IRA vs. Solo 401(k)

Both SEP IRA and Solo 401(k) have certain characteristics that make them ideal for business owners. You should compare both plans to know the most ideal option for your business.

A SEP IRA is a good option for a business with employees, or a business that plans to hire in the future. This retirement plan allows the business to set up multiple retirement plans for its employees. A SEP IRA is easy to set up, and it requires less paperwork. Most 401(k) providers allow business owners to open a SEP IRA account online and manage it on their own.

A Solo 401(k) is a better choice for a business that does not have employees other than the owners and their spouses. It allows the business owner to maximize their overall contributions both as the employer and employee, by contributing as much as possible annually. A Solo 401(k) also has other features that a SEP IRA lacks such as 401(k) loans, catch-up contributions, and Roth option.

Can a Business Owner Have Both SEP IRA and Solo 401(k)?

A business owner can have both SEP IRA and Solo 401(k), but the total annual contributions should not exceed the annual limits provided by the IRS. One of the instances when a business owner can have both plans is if they have one business with employees and another with no employees. For the business with employees, the business owner can make SEP IRA contributions for themselves and their employees. For the business with no employee, the owner can make deferral contributions to a Solo 401(k) and up to 25% of the employer sharing contributions based on their income.