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Understanding SEP IRAs and Solo 401(k)s: Which is Right for You?

Business owners and solo entrepreneurs have the unique opportunity to choose their own retirement savings plans, potentially enjoying tax benefits in the process. Two popular options are the Simplified Employee Pension (SEP) IRA and the Solo 401(k). Both can help you save for retirement, but the best choice depends on your business structure and investment preferences.

What Is a SEP IRA?

A SEP IRA is a retirement plan that can be established by any employer, including self-employed individuals. Authorized by Congress in 1978, SEP IRAs have been around longer than Solo 401(k)s. Setting up a SEP IRA is straightforward. Once you select a provider, such as a bank, credit union, or investment brokerage, you’ll be guided through an easy setup process.

Your investment options may be somewhat limited to traditional choices like stocks or mutual funds. For 2023, self-employed individuals can contribute up to 25% of their net compensation or $66,000, whichever is less. SEP IRAs can now be offered as Roth IRAs, where taxes are paid on current income, as well as traditional, tax-deferred contributions.

SEP IRAs do not offer catch-up contributions for those over 50, as they are fully funded by the employer. If your business grows and you hire employees, your SEP IRA can cover them, provided your guidelines are no stricter than those set by the IRS. However, you must contribute the same percentage of compensation to employee accounts as you do to your own.

Pros of SEP IRAs

• Easy setup
• Potentially larger contributions than traditional or Roth IRAs
• Low administrative and maintenance costs
• Can be set up as late as the tax due date (including extensions)

Cons of SEP IRAs

• No loans from saved funds
• No catch-up contributions
• Employee contributions not permitted

What Is a Solo 401(k)?

A Solo 401(k) is similar to a 401(k) plan offered by businesses but is designed for one-person businesses or one person and a spouse. Created as part of the Economic Growth and Tax Reconciliation Relief Act of 2001, Solo 401(k)s can be either traditional (tax-deferred) or Roth.

To qualify for a Solo 401(k), you must have self-employment activity and no employees other than a spouse. Contributions can be made as both the employer and employee, up to a maximum of $66,000 for 2023. Additionally, if you are at least 50 years old, you may be eligible for a catch-up contribution. Note that overall maximums apply to individuals, not accounts, if you also contribute to a 401(k) through a W-2 employer.

Pros of Solo 401(k)s

• Potentially higher contribution limits
• Flexible contributions
• Ability to contribute in the next calendar year to shelter income from taxes
• Can be set up to allow borrowing from the account

Cons of Solo 401(k)s

• More complicated and expensive setup
• Higher maintenance costs
• Cannot be used if you hire additional employees
• Required reporting to the IRS once the account reaches $250,000

Should You Choose a SEP IRA or a Solo 401(k)?

Many financial experts recommend a Solo 401(k) because it may allow you to shelter more income from taxes and offers the option to borrow from the plan. However, its administrative costs and tax reporting requirements can be higher than those for a SEP IRA. Additionally, if your business grows, a Solo 401(k) is no longer an option.

The Bottom Line

Self-employed individuals are responsible for their own retirement savings. There are tax-advantaged ways to save, and it’s important to choose the right plan for your situation. Consulting a financial planner can help you determine the best retirement savings vehicle for your needs. Regardless of your choice, developing the habit of saving is crucial for your financial health.

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