This Is the Difference between a SEP IRA and a Solo 401(k) – What You Need to Know

This Is the Difference between a SEP IRA and a Solo 401(k) – What You Need to Know

While self-employment has a number of advantages, it also comes with considerable responsibility. One of the issues that small business owners need to consider is how they will save for retirement. Most employees have access to a 401(k) or similar plan through an employer, which can make saving automatic. However, self-employed individuals do not have the same benefit.

When considering methods for retirement savings, it is important to weigh the options, including their particular benefits and drawbacks, to figure out what works best for you. Two of the most common types of retirement savings accounts for self-employed individuals are the simplified employee plan (SEP) individual retirement accounts (IRA) and the solo 401(k).

Here’s what you need to know about each of them:

What to Know about the SEP IRA

The SEP IRA was designed specifically for self-employed individuals and people who own small businesses. The contributions are a percentage of overall income, and employers can also make contributions for their employees. However, contributions for employees must match the same percentage of salary that owners make, in which case this type of account can quickly become prohibitively expensive.

Furthermore, contributions can only be made by the business. This means employees cannot make their own contributions and may benefit more from a different plan anyway. Other plans like a SIMPLE IRA or a 401(k) may prove better choices, although the fee structures for all of these options is different.

From a tax perspective, contributions are considered a business expense and thus become a tax write-off. Contributions can account for up to 25 percent of the owner’s compensation. If the business is set up like a sole proprietorship, the total may look more like 20 percent of total income because of the way in which Schedule C works. The IRS also imposes a maximum contribution to the account outside of the percentage-based total. For 2020, the maximum contribution to a SEP IRA is $57,000. Individuals can open and fund the account up until the day a tax return is filed.

Opening a SEP IRA is generally fairly easy, as most major custodians offer these accounts. Also, the investment options are generally the same as with a regular IRA, which means they are fairly diverse. Individuals cannot take a loan from an SEP IRA and no Roth option is available, so those are two additional key points to keep in mind.

The Basics of a Solo 401(k) Account


The solo 401(k) is another popular choice for self-employed individuals. This type of account allows for both employee and employer contributions. Most major custodians offer a solo 401(k), but the particular rules about these different accounts can vary quite a bit between these providers. This means it is important to read about individual policies.

Only business owners or their spouses can open this sort of account, and other employees cannot be included. However, employer profit-sharing contributions and employee salary deferrals are both allowed. Since the money come from both the business and the individual, the tax situation can get fairly complicated.

In 2020, the IRS limits employee deferrals to $19,500 annually with a $6,500 catchup for people 50 and over, just like with a traditional 401(k). The maximum combined employee contributions plus profit-sharing contributions cannot exceed $57,000 per year, plus the additional $6,500 for people 50 or older. To take tax deductions for the current year, accounts must be opened by the end of that calendar year. However, contributions can be made until the date when a return is filed.

A Roth option is available and loans can be made, although the rules vary between custodians. Also, the investment options are usually similar to those of IRA accounts, but restrictions may apply. Individuals should always verify options prior to opening an account.

Things to Consider When Choosing a Plan

To many people, an SEP IRA and solo 401(k) will look very similar, but some key differences exist. As a result, one option may definitely benefit someone more than the other depending on personal situation. One of the most important things to consider is the contribution structure.

With an SEP IRA, contributions are a percentage of compensation. This means less savings in years with lower income even if the cash to make up this amount is available. This issue can become especially problematic considering that the SEP IRA does not allow for catchup contributions like the solo 401(k).

Thus, individuals have limited control over the amount they save, which could make it necessary to open an additional account. The solo 401(k) does not have the same issue, but this type of account can be more complicated. Also, the savings is not automated as a percentage of income, so people need to be motivated to save.

Another consideration is the difficulties in opening the accounts themselves. SEP IRAs require little work and little planning since the plan can be opened up until taxes are filed, including extensions. The solo 401(k) has a stricter timeline and can involve considerably more upfront paperwork, but this is a one-time issue. The other thing to think about is the ability to borrow against savings, which exists with a solo 401(k) but not a SEP IRA.