Solo 401k vs. SEP IRA: Which is Better?

When businesses closed during the COVID-19 pandemic, it helped many people discover how easy it can be to work from home. Many people quickly began starting their own businesses. After all, it didn’t quire much. All it took was a laptop, an internet connection, and a few SaaS subscriptions.

Of course, internet-based self-employment has many advantages. However, a crucial question arises: “How can freelancers and self-employed individuals save for retirement?”

There are actually several retirement plan options available to self-employed people. But with various types of individual retirement accounts available, determining which is the right one can be unclear or unnecessarily complicated.

For the self-employed, there are two primary options for a personal retirement plan: the Solo 401k and the SEP IRA. In this guide, we’ll explain the differences between the two, outline the pros and cons of each, and discuss some situations where you might choose one over the other.

What is a Solo 401k?

A Solo 401k is a retirement savings plan designed for self-employed people and small business owners. For small business owners to qualify, they must have no employees other than themselves or their spouses.

It is sometimes referred to as an Individual 401(k), Self-employed 401(k), or One-participant 401(k). A Solo 401k is similar to a traditional 401k. It also offers similar benefits to a traditional 401k, such as relatively high annual contribution limits and the ability to make catch-up contributions for those aged 50 or older.

How Does a Solo 401k Work?

The Solo 401k allows the business owner to contribute to the plan as both the employer and employee. This lets you contribute more to your retirement each year when compared to other plans, like a SEP IRA.

As an employee, you can contribute up to 100% of your income up to the annual limit of $22,500. As an employer, you can contribute an additional 25% of your adjusted income up to a total limit of $66,000. In simple terms, it’s as if you’re creating your own employer contribution match program.

Remember that contribution limits go up annually, with the above figures being the limits for 2023.

With a Solo 401k, those aged 50 and older can also make additional catch-up contributions. This helps those nearing retirement maximize their retirement savings during their last years in the workforce. In 2023, Solo 401k savers can contribute an additional $7,500 in catch-up contributions to their plan. This brings the total limit to $73,500.

Who Can Use A Solo 401k?

As stated above, the Solo 401(k) is only available to self-employed individuals who have no employees other than themselves and their spouses.

So long as they meet that requirement, those that qualify for a Solo 401k can include:

  • Sole proprietors
  • LLCs
  • Partnerships
  • Corporations

What is a SEP IRA?

A SEP IRA is a Simplified Employee Pension retirement plan. Despite the name, it functions more like a traditional IRA than a pension. A SEP IRA allows self-employed individuals and small business owners to make tax-deductible contributions to a retirement account.

With a SEP IRA plan, employees don’t typically contribute to the plan themselves. Instead, the employer contributes to each eligible employee’s IRA account, including their own. Employees are immediately vested in the contributions. This means they own the employer’s contributions and can take them if they find new employment.

SEP IRA accounts have higher contribution limits compared to regular IRAs. SEPs allow the business owner to contribute either 25% of an employee’s compensation or the 2023 maximum contribution of $66,000—whichever is less. Compare this to a Traditional or Roth IRA with contribution limits of $6,500 in 2023.

Solo 401k Pros and Cons

As with any retirement plan, a Solo 401k has benefits and disadvantages for retirement savers. Understanding these pros and cons can help you make an informed decision when choosing a retirement plan for yourself.

The pros and cons of a Solo 401k plan include:

Solo 401k Pros:

  • Catch-up Contributions: While Solo 401k plans have similar contribution limits to SEP IRAs, a Solo 401k allows those aged 50 or older to take advantage of catch-up contributions. This ultimately gives a Solo 401k a higher contribution limit for those nearing retirement.
  • Roth Contributions: Solo 401(k) plans can offer a Roth option, allowing for after-tax contributions that grow tax-free. This can be an attractive feature if you anticipate higher tax rates in the future.
  • Loan Option: Solo 401(k) plans often allow you to borrow against your account, which is not typically available with a SEP IRA.
  • Profit-Sharing Contributions: The Solo 401(k) allows for profit-sharing contributions from the employer, while the SEP IRA does not. This potentially enables self-employed individuals to contribute more to their retirement accounts each year.

Solo 401k Cons:

  • Administration and Costs: Solo 401(k) plans can be more complex and costly to set up and administer than SEP IRAs.
  • Limited Eligibility: The Solo 401(k) is only available to self-employed individuals with no full-time employees other than their spouses. If you have employees, you may need to consider a different type of retirement plan.

SEP IRA Pros and Cons

A SEP IRA also comes with advantages and disadvantages. Comparing these to those of the Solo 401k can help you determine which makes the most sense for your situation and retirement needs.

The Pros and Cons of a SEP IRA include:

Pros of a SEP IRA:

  • Easy and Inexpensive to Set Up: A SEP IRA comes with relatively few setup, management, and maintenance costs. This can make it an attractive option for small business owners who want a straightforward retirement plan. Of course, prices can change depending on your plan administrator or broker.
  • Flexible Contributions: With a SEP IRA, there are no minimum contributions. Participants are also never locked into a pre-determined automatic contribution. This allows the employer to decide whether or not to make contributions and how much to contribute each year. This can be beneficial for businesses with fluctuating profits.
  • Inclusion of Employees: Unlike the Solo 401(k), the SEP IRA does not feature a “self-employed” eligibility requirement. Any size business can open a SEP IRA, should they decide it suits their needs.
  • Higher Limits than Traditional IRAs: While a Traditional or Roth IRA typically has low contribution limits, SEP IRAs have much higher limits. This can help increase your year-end tax deduction by up to 10 times more than a traditional IRA.

Cons of a SEP IRA:

  • Lower Contribution Limits: SEP IRAs generally have lower contribution limits than Solo 401(k) plans. This could limit your retirement savings potential.
  • No Catch-Up Contributions: The SEP IRA does not offer catch-up contributions for individuals aged 50 or older, unlike the Solo 401(k).
  • No Roth Option: SEP IRAs do not allow for Roth contributions. This means all contributions are made on a pre-tax basis and do not grow tax-free.
  • No Loan Option: Unlike Solo 401(k) plans, SEP IRAs do not typically allow participants to borrow against their account.

When Is a Solo 401k Better than a SEP IRA?

Of course, everyone’s situation is different. While we can’t offer a specific determination without speaking to you personally, we can still discuss some cases where you might choose one plan over the other.

Below, we’ve listed a few examples of when you might choose to start a Solo 401k over a SEP IRA. The circumstances where you might do so include:

No Full-Time Employees

Solo 401k plans are designed to give small business owners with zero employees a viable retirement plan option. If you’ve started your own business and have no employees other than yourself and your spouse (and have no plans to hire more), a Solo 401k might be your ideal option.

You Want To Maximize Your Retirement Savings

A Solo 401k can offer much higher contribution limits than a SEP IRA, especially once you factor in the catch-up contributions for those 50 and older. This allows you to maximize your retirement savings and expand your plan’s growth potential.

You Want Tax-Free Distributions

Solo 401k plans and SEP IRAs both allow for traditional, pre-tax contributions. These can potentially help you reduce your tax burden in the year you make those contributions. However, you’ll need to pay taxes on any distributions you take during retirement.

But unlike a SEP IRA, a Solo 401k also allows you to make Roth contributions. These contributions are made after tax. While Roth contributions don’t offer any immediate tax benefits, they can be helpful during retirement. Because Roth contributions are made with after-tax dollars, you won’t have to pay income taxes on distributions taken during retirement.

You Want Profit-Sharing Contributions

Profit-sharing contributions can help you further maximize your retirement savings. Because employers make SEP IRA contributions on behalf of their employees, you might consider it a profit-sharing plan. However, those contributions are limited to each employee’s annual earnings.

With a Solo 401k, the profit-sharing contributions you make as an employer are in addition to those you make as an employee. If you plan to make the most out of profit-sharing contributions, a Solo 401k might be your best option.