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

The ranks of self-employed Americans are growing. At the end of 2019, nearly 30% of American workers were self-employed, according to Gallup. The coronavirus pandemic has only accelerated the trend toward self-employment.

Working for yourself doesn’t mean you have to miss out on the tax benefits that regular employees get from standard workplace retirement plans, though. You have two excellent options: SEP IRAs and Solo 401(k) plans. Both offer similar benefits, but their few key differences may make one better for you.

What Is a SEP IRA?

Congress created the Simplified Employee Pension Individual Retirement Account (SEP IRA) in 1978 to extend the IRA concept to small businesses. The term pension in this case is a bit archaic—a SEP IRA is not a defined benefit plan. Rather, it lets the self-employed and small businesses and their employees benefit from simple, tax-advantaged retirement savings accounts similar to personal individual retirement accounts (IRAs).

SEP IRAs are available from most major brokerage firms and easy to set up. Unlike a traditional 401(k) plan, SEP IRAs have little to no administrative overhead. Companies with only a single employee can take advantage of SEP IRAs, meaning they can be a good choice for solo entrepreneurs or gig workers.

Most importantly, SEP IRAs offer more generous tax breaks than personal IRAs. In some cases, the tax deduction for a SEP IRA can be nearly 10 times that of an IRA.

SEP IRA Eligibility and Contribution Limits

Any business with one or more employees is eligible for a SEP IRA, including freelance workers and independent contractors. This includes self-employed people, sole proprietorships, LLPs, C Corporations, and S corporations.

There’s one key feature of SEP IRAs that differentiates them from Solo 401(k)s: Only the employer can make contributions to a SEP-IRA account. Employees are not permitted to make their own elective contributions, although a solo entrepreneur or self-employed person—who is in effect both employer and employee—may contribute acting as employer.

The maximum SEP IRA contribution is the lesser of 25% of adjusted net earnings or $57,000 for 2020 ($58,000 for 2021). Accounting for exemptions, this works out to be about 20% of earnings for self-employed individuals, as calculated using IRS Publication 560. That means a self-employed person under 50 with an annual net profit of $100,000 could contribute a total of $18,587 to a SEP IRA. Notably, since employee contributions are not allowed, SEP IRAs do not allow catch-up contributions for people 50 or older.

Funds paid into the SEP-IRA are fully tax-deductible up to IRS limits, giving the business or self-employed person a dollar-for-dollar reduction in taxable income. For side-hustle workers who don’t pay withholding taxes and worry about their end-of-year tax bill, the deduction can really help.

What Is a Solo 401(k)?

A Solo 401(k) is essentially a 401(k) plan designed for individuals. The plan may also be referred to as an individual 401(k) or a one-participant 401(k).

This tax-advantaged retirement plan is generally limited to just self-employed individuals, though spouses who work at least part-time for them may be eligible to contribute to one as well. If you ran a small business with only one other employee who was not your spouse, then, you would not be eligible to save for retirement in a Solo 401(k).

For self-employed people, however, a Solo 401(k) may offer greater annual contributions and bigger tax deductions than a SEP IRA, depending on your income. Solo 401(k) plans also allow you to make post-tax Roth contributions.

Solo 401(k) Eligibility and Contribution Limits

The Solo 401(k) annual contribution maximum in 2020 is $57,000 and $58,000 in 2021. Unlike SEP IRAs, people age 50 and older can make additional catch-up contributions of $6,500 a year to a Solo 401(k), bringing the potential total to $63,500 ($64,500 in 2021).

Here’s the tricky part: Since the Solo 401(k) owner acts as both employer and employee, both types of contributions can be made—and that means most workers can contribute more and receive a higher tax break. That’s because as an employee they can contribute up to $19,500, but as employer, they can add onto that up to 25% of their adjusted income for a maximum total contribution of $57,000 ($58,000 in 2021).

In the $100,000 example above, our hypothetical under-50 worker with $100,000 in annual net profit could make a total contribution of up to $38,087. Of that total contribution, $19,500 would be the salary deferral as an employee while $18,587 would be a profit-sharing contribution as an employer. If the same worker were 50 or older, they could add $6,500 to that total.

Eligibility requirements are fairly straightforward: Anyone who generates net profits from a sole proprietorship, LLC, or other business organization can open a solo 401(k) as long as they have no employees aside from their spouse.

Who Should Choose a Solo 401(k) Instead of a SEP IRA?

The conventional wisdom regarding the Solo 401(k) vs SEP IRA question is that self-employed people should choose the Solo 401(k) because in most cases, the potential tax savings are higher.

“The primary question many taxpayers ask when deciding between a SEP and a Solo 401(k) is ‘What is the maximum I can contribute?’ In most cases, the Solo 401K allows for a greater contribution and tax deduction, especially in cases where the individual’s self-employment income is limited,” says Dave Cherill, a certified public accountant (CPA) and member of the American Institute of CPAs’ Personal Financial Planning Executive Committee.

But that’s not the only reason to pick a Solo 401(k). Solo 401(k)s also offer features more on par with other employer-sponsored retirement plans that SEP IRAs lack: You can, for example, generally take out a loan from your Solo 401(k) equal to the lesser of $50,000 or 50% of your account balance. Solo 401(k)s also offers catch-up contributions for people 50 and older as well as a Roth option, which lets you pay income tax now in exchange for tax-free withdrawals in retirement.

“I would say that the biggest benefit of all is the Roth option,” says Desmond Henry, a certified financial planner (CFP) based in Topeka, Kan. “For someone who is a high earner, the Solo makes sense because of the Roth option.”

Solo 401(k) accounts tend to offer a bit more flexibility in investment choices, too, Henry says. “If you want to invest in the alternative space, you can do that in a Solo 401(k)…like cryptocurrencies, life insurance, metals,” he says.

Who Should Choose a SEP IRA Instead of a Solo 401(k)?

When a newly minted entrepreneur or gig worker lands at Henry’s door and asks whether to open a SEP IRA or a Solo 401(k), he asks one question: “Do you have any plans to hire an employee, even in the future?” If the answer is maybe, he steers them towards a SEP IRA, which can be used to fund employee retirements.

Hiring just one employee for your business in the future—beyond your spouse—would eliminate the Solo 401(k) as an option. Switching from a Solo 401(k) to a SEP IRA at some future date can be a big hassle, Henry warns.

Entrepreneurs who go with a SEP IRA because of potential future hires have another important consideration: All employee contributions must be the same percentage of compensation. For instance, an entrepreneur who wants to put 10% of their net income into their SEP IRA must put 10% of worker pay into their SEP IRA, too.

But even in some cases where hiring employees simply isn’t in the cards, Henry sometimes advises the self-employed to choose a SEP IRA. Simplified is in their name for a reason: They can be easier to set up than Solo 401(k) plans, according to Henry, and they’re more widely available.

At Vanguard, for example, SEP IRA plans can be set up online while Solo 401(k) accounts require a phone call.

“Every situation is different, and an individual should assess the option that is best for their financial goals, but there is some truth to the fact that a SEP is easier to open,” says Cherill. “In fact, most taxpayers can simply open a SEP account online with their brokerage firm and manage it themselves.”

How to Open a SEP IRA

Nearly all brokerage firms offer SEP IRAs, and in most cases, they can be opened online. A formal written agreement is required, known as IRS Form 5305-SEP, but the brokerage will usually take care of that. Opening fees and annual fees are often zero. One exception is Vanguard, which charges $20 a year, but the firm waives the fee for account balances of more than $10,000.

You can benefit from SEP-IRA tax breaks for a given tax year by opening your account by your annual tax filing deadline of April 15. When opening an account, be sure to note minimum investment requirements and investment options. While SEP IRAs usually have a broader range of choices than 401(k) accounts, the choices are more limited than those available in a standard brokerage account.

How to Open a Solo 401(k)

Opening a Solo 401(k) may be somewhat trickier and more time-consuming. Most major brokerages offer step-by-step instructions on their websites. You’ll need an Employer Identification Number, which you can obtain from the IRS if you don’t have one already.

Solo 401(k) plans must be established by the end of the calendar year for you to benefit from the tax breaks for that tax year.

Annual fees, account minimums, and investment options can vary more widely in a Solo 401(k) plan. It’s possible to find custodians who will allow non-traditional investments like real estate or even Bitcoin, but not all providers allow this.