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SEP IRAs and solo 401(k)s are two of the best retirement plans for the self-employed, and each one holds many benefits. A solo 401(k) is for business owners, their spouses who might be involved in the business, and any business partners. A SEP IRA extends to those people but also allows contributions by employees who are not owners.
Both plans are relatively easy to open and require minimal paperwork from the business owner. Here is a closer look at each.
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SEP IRA overview
A SEP IRA is an individual retirement account (IRA) that allows contributions by small business owners, including the self-employed and employees who are not owners. The employer makes all contributions; employee contributions are not permitted.
The 2024 Internal Revenue Service (IRA) SEP contribution limit is the lower of 25% of the employee’s compensation or $69,000. This limit should increase in most years. In some cases, sole proprietors may be limited to 20% of their compensation. It’s best to check with your tax professional to see if you are in this situation.
Section 601 of the SECURE 2.0 Act of 2022 created a Roth version of the SEP IRA. It became available in 2023, though some custodians may take time before offering it.
If a business has employees, they must be included in the plan in the following situations:
- They are at least 21 years of age.
- They have worked for the business for at least three of the past five years.
- They earn at least an IRS-defined minimum amount of compensation for the year. For 2023 and 2024 the limit is $750.
These are minimum eligibility requirements; the business owner can implement less restrictive requirements if they choose.
When there are eligible employees, the business owner must contribute the same percentage of their compensation as they do for themselves. For example, if the business owner contributes 15% of their own compensation, they must contribute the same percentage of compensation for each eligible employee.
A SEP IRA can get expensive for a business owner with several employees. This requirement is often why SEP IRAs are considered to be an excellent option for self-employed individuals but may not always be appropriate for businesses with a number of employees.
SEP IRAs are readily available at most major brokers and custodians. They can be opened and funded until the business's tax filing deadline for that year, including any extensions.
Eligible investments in a SEP IRA are pretty broad and the same as a traditional IRA. Restrictions include certain alternative investments such as artwork, gold coins, and other collectibles.
As mentioned, a SEP IRA can be established for the prior tax year up to the filing date for your business tax return, including extensions. For the 2023 tax year, the tax filing date for your business tax return for partnerships, multimember LLCs, and S corporations is March 15, 2024. The deadline to file an extension is Sept. 15, 2024. A SEP IRA for the 2024 tax year could have been opened and funded by these deadlines.
Solo 401(k) overview
A solo 401(k), sometimes referred to as an “individual 401(k),” is a type of 401(k) that is available to a business owner with no employees (except a spouse). Unlike a SEP IRA, employees who are not business owners are not eligible to contribute.
A solo 401(k) allows employee contributions in the same amount as a 401(k) offered through an employer. These annual contribution limits for 2024 are $23,000 with a $7,500 catch-up contribution available for those who are 50 or over.
Additionally, solo 401(k)s also allow for employer contributions in the form of profit sharing. These contributions are made as the lesser of 25% of the employee compensation up to a combined limit of $69,000 for 2024. For those who are 50 or over, the combined limit is $76,500 for 2024.
Roth solo 401(k)s can be utilized, and under Section 604 of the SECURE Act 2.0 employer contributions can now be made to the Roth account as well. This option may depend on the solo 401(k) custodian’s capabilities.
Solo 401(k)s must be established by Dec. 31 of the tax year for which you will be making a contribution. Profit-sharing contributions, including extensions, can be made until the account holder’s business tax filing date. Employee contributions must generally be made by Dec. 31 of the year, but some exceptions exist. Be sure to check with your tax or financial advisor to be sure.
SEP IRA vs. solo 401(k): Key differences
| SEP IRA | Solo (401k) | |
|---|---|---|
Who is eligible to contribute? | Business owners and eligible employees | Business owners, spouses involved in the business, business partners |
Employee contributions allowed? | Employer contributions only | Both employer and employee contributions are allowed |
Are Roth accounts allowed? | Yes, this is a new feature under SECURE Act 2.0 rules | Yes |
Contribution limits 2023 | The lesser of 25% of compensation or $69,000 made as employer contributions for 2024 | Employee contributions: $23,000 plus a $7,500 catch-up contribution for those who are 50 or over. In addition, employer profit-sharing contributions of 25% of employee compensation can be made up to a total limit of $69,000 ($76,500 for those who are 50 or over) for 2024 |
Plan loans available? | No | Yes, if the custodian allows |
Taxes | When withdrawn, money from a traditional SEP IRA is taxable; funds in a Roth SEP IRA are subject to normal Roth rules | When withdrawn, money from a traditional solo 401(k) is taxable; funds in a Roth account are subject to normal Roth rules |
When is the SEP IRA the right choice?
For business owners who either have employees or plan to hire in the future, a SEP IRA is a better choice than a solo 401(k).
Additionally, if your cash flow allows you to be flexible about when contributions are made, a SEP IRA would be the better choice. SEP IRA accounts can be opened and contributions made until the business tax filing date, including extensions. Also, a SEP IRA may be the easier option to open at some brokers.
When is a solo 401(k) the right choice?
A solo 401(k) may be the better choice when a solo small-business owner’s income fluctuates. They can contribute as much as 100% of their compensation as an employee contribution up to the annual contribution limits. With a SEP IRA, someone in this situation would be much more limited in the amount they could contribute, as the contribution limits are based on a percentage of the person’s compensation.
A solo 401(k) allows for plan loans, while a SEP IRA does not. Also, a solo 401(k) allows for catch-up contributions for those who are 50 or over, while a SEP IRA does not. In general, a solo 401(k) offers the opportunity to contribute a greater amount to the plan than a SEP IRA does at most income levels.
How self-employed retirement plans work
To open a self-employed retirement plan, you must earn income from your business. This can range from being a self-employed freelancer to owning a business that serves as your main source of income and employment.
A solo 401(k) works in much the same way as a 401(k) offered by an employer. Both plans have the same employee annual contribution limits. Both can be offered as a traditional or Roth 401(k), and plan loans are allowed. In addition to the annual employee contribution limits, a solo 401(k) provides the opportunity to make employer profit-sharing contributions as well.
A SEP IRA only allows employer contributions up to the lesser of 25% of employee compensation or the annual contribution limit. There are no catch-up contributions for a SEP IRA.
Contributions to a self-employed retirement plan potentially will flow through the business tax return and your personal return, depending on the types of contributions and the structure of the business.
For example, pretax employee contributions to a traditional 401(k) will be treated as reducing an individual’s current income in the same fashion as contributions made via contributions to an employer-sponsored 401(k) plan. Employer contributions to either a SEP IRA or solo 401(k) will be treated as a business expense.
TIME Stamp: SEP IRAs and solo 401(k)s each have their own strengths
A SEP IRA and a solo 401(k) are both retirement plans for the self-employed that offer opportunities to save for retirement. Both offer tax-deferred growth (tax-free in the case of a Roth account) while the money is invested.
Both types of accounts offer tax breaks to the self-employed account holder and access to a wide range of investment options. The right type of account will depend on the needs and circumstances of the self-employed individual, including their business cash flow and a host of other factors.
Frequently asked questions (FAQs)
How do you open a SEP IRA?
A SEP IRA can be opened through most brokerage firms, and applications can often be completed online. An IRS Form 5305-SEP is required, but most brokerage firms will complete this and submit it for the applicant. Once the account is opened, you will generally contribute via an online transfer or by sending in a check.
You can open and contribute to a SEP IRA by the contribution date for the most recent tax year, generally the tax filing date for the business, including extensions. When looking for a place to house your SEP IRA, be sure to consider any account fees and the types of investments that are available to you and others participating.
The lineup of available investments might be broader, but it can still be more limited than with a basic brokerage or an IRA account at the same broker. SEP IRAs can be opened at many firms, including Empower, among others.
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How do you open a solo 401(k)?
Opening a solo 401(k) is more involved than opening a SEP IRA, but overall the process is not too complicated. Most brokers and custodians offer an online application with step-by-step instructions. You will need an employer ID number (EIN) for your business, which you can obtain from the IRS.
A solo 401(k) must be opened by Dec. 31 of a given tax year in order to make contributions for that year. Employee contributions for a given tax year can generally be made up to Dec. 31 as well, while employer profit-sharing contributions can generally be made up to the business tax filing date, including extensions. A solo 401(k) can be opened with a number of brokers and custodians, including J.P. Morgan.
Can you have both a solo 401(k) and a SEP IRA?
Yes, but there is an exception. If your broker or custodian opens the SEP IRA using IRS Form 5305, you cannot establish a solo 401(k) for the same business. Otherwise, you can have both plans. However, there may or may not be an advantage to doing this.
Generally, a solo 401(k) allows you to contribute more and may be the best option if you don’t have any employees. With the ability to contribute 100% of your salary or compensation amount to the plan up to the annual contribution limits, a solo 401(k) allows for greater contributions more quickly than a SEP IRA.
A related question that often comes up is whether you can contribute to both a 401(k) offered by an employer and a solo 401(k) or SEP IRA for your own business. The answer is generally yes. In the case of a solo 401(k), one set of annual employee contribution limits applies.
For example, in 2024 the limits between the two plans would be a combined $23,000 plus an additional $7,500 in catch-up contributions for those who are 50 or over. If you have a side hustle in addition to your full-time job, it certainly makes sense to contribute to a retirement plan for that side gig. You will just want to do a little planning to determine your best options.
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