SEP vs Solo 401(k): What Plan is a Better Choice

Working for yourself doesn’t mean you have to miss out on the tax benefits that regular employees get from standard workplace retirement plans. If you're self-employed and looking for a retirement plan, you may be trying to decide between a solo 401(k) and a SEP IRA. With both retirement plans, your investment in your tax-favored retirement:

• creates tax deductions for the money you invest in the plan,
• grows tax-deferred inside the plan, and
• is subject to tax only when you take the money from the plan.

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.?

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 $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 an SEP IRA. 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 the 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 is $58,000 in 2021. Unlike SEP IRAs, people aged 50 and older can make additional catch-up contributions of $6,500 a year to a Solo 401(k), bringing the potential total to $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 employees they can contribute up to $19,500, but as employers they can add onto that up to 25% of their adjusted income for a maximum total contribution of $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.

Solo 401(k) vs SEP IRA

Both a solo 401(k) and a SEP IRA can supercharge retirement savings for self-employed people.?

If you have no employees, and are deciding between SEP IRA and solo 401(k), consider the following:

• SEP IRA is easier to set up and cheaper to administer than solo 401(k)
• Solo 401(k) has one filing requirement, Form 5500, once your retirement account reaches $250,000 in assets. SEP does not have a requirement to file Form 5500
• Solo 401(k) will typically allow you to contribute more into your retirement account per year, which will also result in a higher tax deduction

As always, you should first consult with your tax professional and financial advisor before making a decision.

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