Solo 401(k) vs SEP-IRA

Retirement planning is a crucial part of anyone’s long-term financial planning goals—and that’s true for business owners and entrepreneurs, too. As the owner of a sole proprietorship or small business, understanding the various options available for retirement accounts can seem overwhelming; it’s not as simple as signing some paperwork during onboarding, as it is for so many salaried workers.

Good news: this article will delve into two popular (and powerful) retirement plans the IRS has created for self-employed individuals: the solo 401(k) and the SEP-IRA.

A solo 401(k) plan, also known as a one-participant 401(k) or an individual 401(k), is similar to the normal employer-sponsored retirement account, but tailored to meet the needs of self-employed people or sole proprietors who don’t have any full-time employees.

These plans offer distinct advantages including tax-deferred growth and potential tax breaks, as well as the opportunity for both employer contributions and employee contributions—which means a much higher maximum contribution overall.

Alternatively, a SEP-IRA (Simplified Employee Pension-Individual Retirement Account) is a retirement plan that allows employer contributions on behalf of all eligible employees, which can include the business owner or sole proprietor.

The SEP-IRA is a particularly attractive option for self-employed people and small business owners who wish to save for their own retirement and also offer a retirement benefit to their employees.

Let’s take a closer look at both.

Comparison of SEP-IRA and Solo 401(k) Plans

This section provides a detailed comparison of SEP-IRA and solo 401(k) plans. We’ll break down the differences and similarities between these plans in terms of contribution limits, eligibility requirements, and other significant features so you can quickly determine which plan aligns best with your business and personal retirement goals.

Include a table or graphic to visually summarize the differences between the plans.

Contribution limits and eligibility

Contribution limits for solo 401(k) plans are generally higher than those for SEP-IRA plans. For instance, in 2023, the total contribution limit for a solo 401(k) plan was $66,000 for individuals under age 50 and $73,500 for those aged 50 and over.

In essence, it’s basically like having a normal, employer-sponsored 401(k), except with the ability to make both employee and employer contributions. (Employer-sponsored 401(k) plans are also capped at $66,000 in 2023, though the employee can only contribute $22,500 of their wages, or $30,000 with catch-up contributions; the rest must come from employer match funds.)

Comparatively, SEP-IRA plans cap contributions at 25% of employee compensation (net earnings from self-employment, less deductions) available de up to a limit of $66,000 in 2023. The eligibility criteria for both plans can differ based on factors such as self-employment income, age, and the type of business you operate. Compare these totals to the annual contribution limits for traditional IRAs and Roth IRAs, and you’ll begin to see how powerful these types of accounts are for entrepreneurs.

Employer and employee contributions

One of the key differences between SEP-IRAs and solo 401(k)s: SEP-IRA plans only allow for employer contributions, which are calculated as a percentage of an employee’s compensation. Conversely, solo 401(k) plans allow for both employer and employee contributions, providing an attractive option for small business owners looking to maximize their retirement savings. (Basically, it means you get to pay for your own employer match.)

Catch-up contributions and Roth contributions

Both SEP-IRA and solo 401(k) plans offer the advantage of catch-up contributions for individuals who are aged 50 or older. However, solo 401(k) plans have an additional advantage as they allow for both pre-tax (tax-deductible) and Roth contributions, while SEP-IRA plans only allow for pre-tax contributions.

The ability to make Roth contributions, or to seed your account with after-tax dollars, offers the opportunity for tax diversification. It could also be an advantage if you anticipate being in a higher tax bracket in retirement, since you’ll be able to take your eventual distributions tax-free.

Of course, contributing pre-tax money has its own benefits, such as lowering your overall taxable income in the tax year the contributions are made—which can be especially valuable to those paying self-employment tax.

Loan provisions

Although it’s not usually someone’s first choice, sometimes, life gives you lemons—and being able to take a loan from your retirement account can be one way to make lemonade (or at least get rid of some of the lemons).

But when it comes to borrowing against your retirement account, solo 401(k) plans allow for loans, while SEP-IRA plans do not. If you’re considering taking out a loan from your solo 401(k) plan, it’s crucial to fully understand the long-term implications on your retirement savings, such as potentially slower account growth and the risk of fees if you can’t repay the loan.

In addition, as with regular IRAs, keep in mind that early withdrawals come with a 10% additional penalty along with the normal income tax that will need to be paid on the funds, with the exception of demonstrable financial hardship.

Establishment and operational requirements

Solo 401(k) plans may come with more administrative responsibilities and potentially higher costs than SEP-IRA plans do. These could include setting up the plan, annual reporting, and possibly requiring an annual audit. However, they may also offer more flexibility in terms of investment options and contribution limits.

On the flip side, SEP-IRA plans are typically easier and less costly to set up and maintain, which could make them a more convenient option for business owners who prefer simplicity and have fewer resources to devote to retirement plan administration. Many brokerages and providers offer SEP-IRA plans along with other types of retirement accounts, and it takes little more than filling out some forms to open one.

Reporting requirements

Both solo 401(k) and SEP-IRA plans require annual reporting to the IRS, but the requirements differ between the two types of account. For solo 401(k) plans with more than $250,000 in assets, an annual Form 5500-SF must be filed.

Meanwhile, SEP-IRA plans don’t require annual filings, but you are required to provide specific plan information to your employees. Not adhering to these reporting requirements can result in penalties and other tax implications—so if you have additional questions, it’s always a good idea to consult a tax professional to avoid an unpleasant surprise.

Pros and Cons of SEP-IRA Plans

In this section, we delve deeper into the strengths and weaknesses of SEP-IRA plans to give you a well-rounded perspective.

Advantages of a SEP-IRA Plan

1. Simplicity and ease of setup: SEP-IRA plans shine in their simplicity and ease of setup. They’re straightforward to establish and maintain, and they require minimal paperwork, making them appealing to those who value convenience.
2. Lower costs: SEP-IRA plans usually come with fewer administrative fees and costs compared to solo 401(k) plans. Lower costs can translate into higher returns over the long run.
3. Flexibility in contributions: Employers aren’t required to make contributions to their SEP-IRA every year, which can be helpful in businesses with a lot of volatility or leaner years when profits are down.

Disadvantages of a SEP-IRA Plan

1. Limitations on contributions: While a SEP-IRA allows for substantial contributions, they’re limited to 25% of compensation or $66,000, whichever is less.
2. Lack of employee contributions: SEP-IRAs don’t allow for traditional employee deferrals, which means employees cannot choose to contribute to their SEP-IRAs from their paychecks.
3. No loan provisions: Unlike solo 401(k) plans, SEP-IRA plans don’t allow loans—and taking an early distribution could lead to hefty fees and taxes.

Pros and Cons of Solo 401(k) Plans

Next, we take a balanced look at the solo 401(k) plan, exploring both its benefits and drawbacks.

Advantages of a Solo 401(k) Plan

1. Higher contribution limits: With a solo 401(k), you can make both employee and employer contributions, leading to potentially higher total contributions compared to a SEP-IRA.
2. Catch-up contributions: Solo 401(k) plans offer catch-up contributions for those over 50, providing an opportunity to boost retirement savings later in life.
3. Loan provisions: Solo 401(k) plans offer the option to take out a loan against the account balance, providing flexibility—and liquidity when needed.
4. Roth option: Solo 401(k) plans allow for Roth contributions, providing tax diversification for your retirement savings and the opportunity to take tax-free withdrawals at retirement.

Disadvantages of a Solo 401(k) Plan

1. More complex setup: Compared to SEP-IRAs, solo 401(k) plans can be more complicated to establish and may involve higher setup costs.
2. Stringent reporting requirements: Solo 401(k) plans come with strict reporting requirements, including potential annual audits. Failure to comply with these requirements can lead to penalties and loss of tax benefits—and they can also just be a lot to keep up with.
3. Administrative costs: Solo 401(k) plans may incur higher ongoing administrative costs compared to SEP-IRAs.

Choosing Between SEP-IRA and Solo 401(k) Plans: Which Is Better for Business Owners?

When it comes to choosing the right plan for your business, a one-size-fits-all approach just doesn’t cut it. You must take into account many factors including your income, presence (or absence) of full-time employees in your business, your retirement savings goals, your ability and willingness to manage administrative responsibilities, and the flexibility you desire in managing your contributions.

Solo practitioners with high incomes might prefer the higher contribution limits and flexibility of a solo 401(k), while business owners with employees might prefer the relative simplicity and lower cost of the SEP-IRA.

In Summary

The process of selecting the right retirement plan is a critical step for small business owners, but it doesn’t have to be a daunting task. Capitalize is a partner that can manage the entire retirement plan process for you—particularly if you’ll be rolling an old 401(k) over into an IRA. By working with Capitalize, you can save time, reduce stress, and rest assured knowing that your rollover is handled by a team of industry experts.

Regardless of the retirement plan you choose, it’s crucial to consult with a financial advisor who can provide personalized advice tailored to your specific situation. By doing so, you can navigate the complexities of personal finance and make an informed decision that aligns with your unique financial goals and business needs.