Self-employed? Here’s how to pick between a SEP IRA and Solo 401(k) for your retirement

Article | February 09, 2024

Authored by Weinlander Fitzhugh

If you’re self-employed or considering self-employment, you may be worried about handling your own retirement planning. 

In this article, we’ll explore the SEP IRA and the Solo 401(k), focusing on how these popular retirement plans can play a vital role in your long-term financial strategy. 

SEP IRAs

A Simplified Employee Pension Individual Retirement Arrangement (SEP IRA) is a retirement savings option for businesses of any size and structure. However, it tends to make the most sense for the self-employed or small businesses with few employees. 

Advantages

Ease of setup and management: one of the most appealing aspects of the SEP IRA is its straightforward setup process and minimal maintenance requirements. This simplicity is particularly beneficial for those without extensive resources to manage more complex retirement plans.

Higher contribution limits: unlike traditional or Roth IRAs, SEP IRAs allow for significantly larger contributions. For 2024, the tax-deductible contribution limit is the lesser of 25% of an individual’s net compensation, or $69,000. 

Roth option: as of 2023, there is a Roth option for SEP IRAs, which allows after-tax contributions. This feature can be beneficial for those who anticipate being in a higher tax bracket during retirement, as withdrawals from a Roth account are tax-free.

Flexibility for businesses with employees: a SEP IRA can be easily expanded to cover employees if your business grows. However, the plan must include any eligible employees, and contributions for employees must match the percentage contributed to the owner’s account, which may not be ideal for many small businesses.

Drawbacks

Lack of loan options: SEP IRAs do not permit loans from the accumulated funds. For individuals who might need liquidity or access to their retirement savings, this could be a significant drawback.

No catch-up contributions: SEP IRAs do not offer the option of catch-up contributions, a feature that is often available in other retirement accounts. This could be a concern for those looking to increase their retirement savings later in their careers.

No employee contributions: the SEP IRA is an employer-funded plan, meaning that employees cannot contribute to their own SEP IRA accounts. This aspect may limit the overall growth potential of an employee’s retirement savings, as they rely solely on employer contributions.

Overall, SEP IRAs provide a valuable retirement saving tool, particularly for those seeking simplicity and higher contribution limits. However, it’s important to weigh these benefits against the limitations to determine if a SEP IRA aligns with your specific retirement goals and business structure. 

Solo 401(k)

A Solo 401(k) plan, specifically designed for self-employed individuals and their spouses, is a retirement savings option akin to the traditional 401(k) plans offered by larger companies. The plan can be used by any type of business structure but will only cover the self-employed individual and their spouse, as long as the spouse works at least part-time for the entity. 

Advantages

Higher contribution limits: one of the Solo 401(k)’s most attractive features is its high contribution limit. For 2024, contributions can reach up to $69,000, with an additional $7,500 as a catch-up contribution for those aged 50 and above. 

This plan allows contributions in dual roles – as both employer and employee. As an employee, the individual can contribute up to $23,000 (or $30,500 if eligible for catch-up contributions). As the employer, the individual can make further contributions up to 25% of their adjusted net income. The combined limit of these contributions is currently $69,000 unless the individual qualifies for catch-up contributions. 

Roth option: the Solo 401(k) includes both traditional and Roth options. The Roth 401(k) allows after-tax contributions, which is beneficial for those expecting to be in a higher tax bracket during retirement, as withdrawals will be tax-free.

Loan options: if your plan permits, Solo 401(k)s offer the ability to take loans against your retirement savings. Generally, the loan amount is capped at the lesser of $50,000 or 50% of the account balance. This feature provides financial flexibility, allowing access to funds without necessarily incurring early withdrawal penalties. 

Contribution flexibility: contributions to a Solo 401(k) can be varied each year, offering flexibility to adjust savings based on changing income levels.

Investment options: Solo 401(k)s allow for a broader range of investment choices, including options in the alternative investment space. This flexibility may enable diversification and the ability to invest in non-traditional assets like cryptocurrency. 

Drawbacks

Administrative complexity and costs: setting up and maintaining a Solo 401(k) is generally more complex and costly compared to SEP IRAs. This can be a deterrent for those seeking simplicity in managing their retirement accounts.

Specific eligibility requirements: solo 401(k) plans are strictly for self-employed individuals with no employees other than their spouses. This eligibility requirement limits the plan’s applicability as soon as additional employees are hired. 

If the business hires any additional employees, the plan will have to transition into a regular 401(k), which will involve more administrative tasks and may require a third-party administrator. There may also be restrictions on non-traditional investments. Alternatively, the business could terminate the solo 401(k) and roll over the assets to an IRA. 

Reporting requirements: once the account balance in a Solo 401(k) exceeds $250,000, IRS reporting becomes mandatory, which can add to the administrative burden.

A Solo 401(k) is a compelling option for the self-employed, particularly those seeking high contribution limits and loan options. However, its administrative demands and specific eligibility criteria are important factors to consider.

Making the choice

Choosing between a SEP IRA and a Solo 401(k) involves strategic considerations that extend beyond basic features and limitations. The decision should be aligned with your business structure, retirement goals, and financial circumstances.

For self-employed individuals or small business owners without employees, a Solo 401(k) often stands out due to its higher contribution limits and the flexibility of both employer and employee contributions. This plan suits those aiming to maximize their retirement savings, especially if they can manage the more complex setup and ongoing administrative requirements. The option to borrow against the plan can also be a strategic advantage in certain situations, offering liquidity without the tax penalties associated with early withdrawals.

For those close to retirement age, the catch-up contribution feature of Solo 401(k)s is another notable advantage.

A SEP IRA may be more suitable for those looking for simplicity and ease of management, especially when the business might expand to include employees other than a spouse. The SEP IRA requires equal percentage contributions for all eligible employees, including the owner, which can be a significant consideration for businesses planning to grow. 

Another factor to consider is your current and projected tax situation. For both types of plans, the Roth option might be more advantageous if you anticipate being in a higher tax bracket in retirement, allowing you to pay taxes on contributions now and enjoy tax-free withdrawals later. On the other hand, if you expect to be in a lower tax bracket in retirement, the traditional options, which allow for tax-deferred growth, might be more beneficial.

While both SEP IRAs and Solo 401(k)s offer unique advantages, the choice ultimately depends on your individual business needs, retirement goals, and tax considerations. 

This article is intended to provide a brief overview of two popular retirement plans for the self-employed. It is not an exhaustive list of available options and considerations. If you’d like to learn more about retirement planning options, please contact our office for personalized advice.