Self-employed individuals miss out on employer-sponsored benefit programs, but they can still access powerful tax-advantaged accounts to help fund their retirements. The Solo 401(k) and SEP IRA are two of the most popular choices.
If you’re a freelancer, independent contractor, or small business owner, here’s everything you need to know about their differences to determine which is best for you.
What Is a SEP-IRA?
SEP-IRA is short for Simplified Employee Pension (SEP) Individual Retirement Arrangement (IRA). In addition to being a mouthful, the name is a bit of a misnomer. SEP-IRAs have very little in common with pensions and are not defined-benefit plans.
Like traditional IRAs, they’re defined-contribution plans where contributions are tax-deductible in the year you make them. In addition, the capital gains and dividends generated within the account are tax-deferred until withdrawn.
Unlike traditional IRAs, SEP-IRAs are primarily profit-sharing plans for the self-employed and their employees. Business owners can contribute company earnings for each plan participant, but employees can’t contribute through salary deferrals.
For employees to put funds into their SEP-IRA, they must forego making those contributions to their Traditional or Roth IRAs. The $6,000 contribution limit for IRAs in 2021 and 2022 applies to Traditional, Roth, and SEP-IRAs, collectively.
The maximum contribution for each SEP-IRA participant is the lesser of 25% of their salary and $58,000 in 2021 or $61,000 in 2022.
If you own a sole proprietorship or partnership and have no wages, the limit is 20% of your net earnings minus half the self-employment tax from your IRS Form 1040 instead.
Notably, employers must make proportional contributions for themselves and all eligible employees. In other words, every participant’s contribution must be the same percentage of their compensation.
Though you can use less strict requirements, eligible employees must include those that meet the following criteria:
- Age 21 years or older
- Earned $650 or more during the tax year
- Worked for the business in at least three or the last five tax years
For example, say you own a corporation. You pay yourself a $100,000 salary, and your eligible employee’s salary is $50,000. If you contribute $10,000 to the SEP-IRA for yourself, you must contribute $5,000 for your employee so that both of you receive 10%.
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What Is a Solo 401(k)?
A Solo or Individual 401(k) plan is the same type of account as an employer-sponsored 401(k) plan, only for business owners with no employees. Otherwise, they provide much of the same benefits and follow many of the same rules.
For example, a Solo 401(k) allows tax-deductible contributions and tax-deferred asset growth within the account. Alternatively, you can choose to make Roth contributions. They’re taxable when you make them but tax-free upon withdrawal.
Another trait they have in common is that employers and employees can contribute. However, as a self-employed individual, you play both roles. That gives you a significant degree of control over the amount you put into the account.
Your maximum employee contribution is the same as an employer-sponsored 401(k)’s. You can defer 100% of your compensation up to $19,500 in 2021 and $20,500 in 2022, plus a $6,500 catch-up contribution if you’re over 50 years old.
Through your employer role, you can also make profit-sharing contributions. Like a SEP-IRA, the limit is 25% of your salary or 20% of your net business earnings minus half your self-employment taxes.
The total amount you can contribute to the account is $58,000 in 2021 and 61,000 in 2022. That limit applies to your employee and employer contributions combined.
Solo 401(k)s usually let you save more each year than other self-employed retirement plans. Typically, the only reason not to have one is that they’re only available to businesses with no full-time employees other than the owner and their spouse.
Differences Between the Two
Solo 401(k)s and SEP IRAs are both defined-contribution retirement accounts with similar tax advantages for the self-employed. However, there are significant enough differences between them that one will usually be a clearly superior choice for you.
Here are the primary things to consider when choosing between the two retirement plans.
You can only use a Solo 401(k) plan if your business has no employees other than you or your spouse. If you hire someone else to help with your operation full-time, you won’t be able to open or contribute to one.
Conversely, you can still open and contribute to a SEP-IRA with full-time employees. But remember, if they meet the eligibility requirements discussed in the previous section, you have to make proportional contributions for them too.
When you’re choosing a retirement plan, one of the most significant considerations is the amount each one lets you save each year. The Solo 401(k) and SEP-IRA contribution rules lead to drastically different retirement savings amounts.
The primary differences between their contribution restrictions are the following:
- Employee contributions: Solo 401(k) plans allow employees to defer 100% of their salary, up to $19,500 in 2021 and $20,500 in 2022, while SEP-IRAs generally don’t allow employee contributions.
- Catch-up contributions: Solo 401(k) plans allow up to $6,500 in annual catch-up contributions for people 50 years or older, but SEP-IRAs don’t.
As you can see, the contribution rules for Solo 401(k)s are generally more favorable than those of SEP-IRAs. In most cases, you’ll be able to save much more money each year with a Solo 401(k) than you would with a SEP-IRA.
For example, say you’re a 55-year-old sole proprietor with $100,000 in net earnings during 2021. Because you have no salary, you could contribute 20% of your net earnings after self-employment taxes to a SEP-IRA.
The self-employment tax is 15.3% and applies to 92.35% of your self-employment income, so you’d owe $14,130 that year. Half of that amount is $7,065. $100,000 minus $7,065 is $92,935, and 20% of that is $18,587.
Conveniently, that same calculation gives you your maximum employer contribution through a Solo 401(k). As a result, if you only made employer contributions, you’d save $18,587 with both retirement accounts.
However, a Solo 401(k) also lets you make up to $19,500 of employee contributions. Since you’re over age 50, you can also make $6,500 of catch-up contributions. That means you’d be able to contribute a whopping $44,587 with the Solo 401(k).
Tax Deduction Timing
Both Solo 401(k)s and SEP-IRAs let you make traditional contributions that reduce your tax liability in the year you make them. Growth within the accounts is also tax-deferred until you make withdrawals.
However, Solo 401(k)s also let you make Roth contributions. These won’t lower your tax liability the year you make them, but you won’t have to pay any taxes on the back end when you take your money out of the account.
Generally, you’ll pay a 10% penalty if you take money out of your retirement accounts before age 59 ½. That restriction applies to both SEP-IRAs and Solo 401(k)s.
However, Solo 401(k)s let you borrow against your funds and avoid that penalty. There are complex considerations involved, and you have to pay the amount back within five years, but it can be an asset in emergencies.
That said, borrowing against your retirement is highly inadvisable in most situations. As a result, this difference shouldn’t be much of a deciding factor.
One advantage of a SEP-IRA over a Solo 401(k) is that you have until you file your taxes to open a SEP-IRA for a given tax year. Conversely, you have to open your Solo 401(k) before the end of the tax year or you’ll lose your ability to contribute for that year.
If both accounts are open by the end of the year, you have until you file your taxes to make a profit-sharing contribution to both. However, you only have until December 31st of the tax year to make employee contributions to your Solo 401(k).
In general, Solo 401(k)s have more demanding administrative requirements than SEP-IRAs. If you have more than $250,000 in your Solo 401(k), you must file an annual report with the IRS, but there’s no need to do so with a SEP-IRA.
Which One Should I Choose?
Generally, the Solo 401(k) is the superior retirement account for a business owner with no employees. It has several significant advantages over SEP-IRAs, including the following:
- Higher annual contribution limits
- Employee and employer contribution options
- Access to traditional 401(k) and Roth 401(k) contribution types
However, if you already have or plan to hire full-time employees other than you and your spouse, you won’t be able to open or contribute to a Solo 401(k). In these cases, a SEP-IRA would be the only one of the two retirement account options available to you.
That said, picking a retirement account for your business is a significant and complicated decision. Before you choose one, it’s always a good idea to consult a Certified Public Accountant (CPA) or another expert to get personalized tax advice.
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Can You Contribute to Both a SEP-IRA and Solo 401(k)?
Yes, you can contribute to both a SEP-IRA and Solo 401(k) during the same tax year. However, there’s usually no reason to do so. Your maximum contribution amount is generally the same whether you use a Solo 401(k) by itself or together.
However, there are some situations where you may want to contribute to both. For example, if you already contributed to a SEP-IRA during the tax year, you may wish to open a Solo 401(k) to take advantage of the employee salary deferral.
Is a Solo 401(k) Worth It?
Yes, a Solo 401(k) is worth it for the average self-employed person. It typically gives you the ability to save far more for retirement than you would with other account types. If you’re over the age of 50, you could save a whopping $67,500 in 2022.
In addition, Solo 401(k)s have more flexible annual contributions than other self-employed retirement accounts. They also let you make Roth 401(k) contributions that aren’t tax-deductible when you make them but are tax-free upon withdrawal.
Is a Solo 401(k) Tax-Deductible?
Generally, all retirement contributions to your Solo 401(k) are tax-deductible, whether you make them via your employer or employee persona.
In addition, the dividends and capital gains your assets generate while they remain in the account are tax-deferred. That means you won’t pay any taxes on them until you withdraw your funds from the account.
The only reason contributions to a Solo 401(k) wouldn’t be tax-deductible is if you create a Roth Solo 401(k). Roth contributions are taxable the year you make them, but the funds are completely tax-free when you withdraw them.
Can I Contribute 100% Of My Salary to My Solo 401(k)?
With a Solo 401(k), you can make employee contributions up to 100% of your salary. However, there’s a hard limit of $19,500 in 2021 or $20,500 in 2022, plus a $6,500 catch-up contribution if you’re over the age of 50.
You can also make an employer contribution of up to 25% of your salary. However, it can’t exceed $58,000 in 2021 or $61,000 in 2022 when you combine it with your employee contributions, not including any catch-up amounts.
In other words, if your salary is within those limitations, you can contribute 100% of it to your Solo 401(k). However, if you earn more than that, you won’t be able to defer your entire salary.
*The information provided in this post does not, and is not intended to, constitute business, legal, tax, or accounting advice and is provided for general informational purposes only. Readers should contact their attorney, business advisor, or tax advisor to obtain advice on any particular matter.