SEP IRA vs. Solo 401(k): Find the Best Match for You

By Bob Haegele

March 20, 2023

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While saving for retirement is crucial, knowing what that looks like can be difficult. Self-employed individuals must choose between accounts like a SEP IRA or a solo 401(k). Both accounts have advantages, but knowing which to choose is not always easy.

See: 3 Ways To Recession-Proof Your Retirement

As a self-employed person, you can potentially open either account — or both. In either case, you will have tax advantages, such as setting aside some of your income in a tax-deferred account. However, the differences between these accounts can make one or the other better, depending on your situation.

Understanding the SEP IRA

Congress created the simplified employee pension IRA in 1978 to provide employers with a simpler way of providing retirement benefits for themselves and their employees. The goal was to create an IRA for small business owners and qualified employees. These plans have higher contribution and income limits than IRAs for individuals, yet they function like traditional IRAs in many ways.

SEP IRAs are also easy to set up and maintain in many cases. SEP IRAs have minimal overhead, so they’re available with most online brokerages, often with no added fees. Even if your company only has one employee, you can still open a SEP IRA.

The contribution limit for a SEP IRA is the lesser of 25% of compensation (20% of net income for self-employed individuals) or $66,000 in 2023. The IRS adjusts the dollar amount for inflation each year. However, that dollar amount is much higher than the contribution limit for traditional and Roth IRAs.

Businesses can use SEP IRAs with more than one employee, which makes them useful if you have employees now or think you will in the future. However, all employee contributions must be the same percentage of compensation for all employees. So if you contribute 15% of your salary to the plan, you must also contribute 15% of each employee’s salary.

Advantages of a SEP IRA

• Easy to set up and maintain
• High contribution limits compared to other plans
• No annual filing requirement for the business

Disadvantages of a SEP IRA

• Contributions for each person must be the same percentage of compensation
• Employee contributions by deferring salary are not allowed in a SEP IRA

Understanding the Solo 401(k)

Solo 401(k) accounts are retirement plans for a single participant with no full-time employees. However, a spouse who works for the business may be able to contribute in some cases. Business owners with at least one full-time employee who is not their spouse are not eligible to contribute to a solo 401(k).

Despite this limitation, solo 401(k) plans can be an excellent choice for business owners who don’t intend to hire full-time employees. They can have higher contribution limits than other plans and may sometimes allow you to contribute more with less income than a SEP IRA.

Solo 401(k) plans allow you to contribute 100% of your income up to the contribution limit of $22,500 in 2023. The plan also allows an employer contribution of 25% of compensation for a total contribution limit of $66,000 in 2023. And for those ages 50 and over, there is a catch-up contribution of up to $7,500 in 2023 for a maximum contribution of $73,500 in 2023.

Another benefit of solo 401(k) plans is that they have several features that SEP IRA plans lack:

• Roth plans: Solo 401(k) plans have a Roth option, which allows you to make tax-free withdrawals in retirement. SEP IRA plans don’t have a Roth option.
• Employee deferrals: With a solo 401(k) plan, participants can make an employee compensation contribution and a profit-sharing contribution. This enables those with lower incomes to contribute more to the plan.
• 401(k) loans: Solo 401(k) plans may have the option to take out a tax-free loan equal to the lesser of $50,000 or 50% of the account balance.

Solo 401(k) plans can be an excellent option for self-employed individuals with no employees who want to maximize their retirement contributions. They can also have more flexibility around investments and distributions in some cases.

Advantages of a Solo 401(k)

• Includes a Roth option
• Can have more investment options than SEP IRA plans
• Some plans allow loans
• Can allow participants to contribute with a lower salary

Disadvantages of a Solo 401(k)

• It can be more challenging to set up and maintain than SEP IRA plans
• A 10% penalty may apply for early withdrawals made before the age of 59 ½ unless an exception applies
• Contributions may be limited if the individual also participates in another employer-sponsored retirement plan

Comparing SEP IRA and Solo 401(k) Plans

SEP IRA and solo 401(k) plans both offer tax-advantaged savings options. However, some key differences between the two may make one more suitable for your needs.

• Eligibility: Anyone who is self-employed can open a SEP IRA. This includes those who work as sole proprietors and freelancers. Conversely, solo 401(k) plans are only available to self-employed people with no employees (other than a spouse, in some cases).
• Contribution limits: In 2023, the maximum contribution limit for a SEP IRA is $66,000 or 25% of compensation, whichever is less. For solo 401(k) plans, the contribution limit is $66,000 or 100% of compensation, whichever is less.
• Catch-up contributions: You can make up to $7,500 in catch-up contributions to solo 401(k) plans in 2023. SEP IRA plans don’t allow catch-up contributions.
• Employer contributions: With a SEP IRA, typically only the employer contributes to the account. However, a business owner can contribute to a solo 401(k) in two capacities, as both an employer and an employee.
• Loan provisions: Solo 401(k) plans generally allow participants to take out loans from their retirement accounts, while SEP IRA plans do not.

Can I Have Both a SEP IRA and a Solo 401(k)?

SEP IRA and solo 401(k) plans both have advantages and can be tough to choose from. If you are having trouble deciding, you can potentially contribute to both plans. Remember that you can’t contribute to a solo 401(k) if you have full-time employees. In that scenario, you can only have a SEP IRA.

Can I Contribute More to a SEP IRA or a Solo 401(k)?

The maximum contributions are similar for the two plans. Solo 401(k) plans have a contribution limit of $66,000, while SEP IRA plans have a maximum contribution of the lesser of $66,000 or 25% of compensation. However, that can limit SEP IRA contributions for those with lower salaries, and solo 401(k) plans allow catch-up contributions of $7,500 in 2023. Thus, solo 401(k) plans have a higher contribution limit for individuals.

Which Is Better, a SEP IRA or a Solo 401(k)?

SEP IRA and solo 401(k) plans have advantages that can make them the right choice for different people. Neither the SEP IRA nor the solo 401(k) is better in all cases, but generally, you can only have a solo 401(k) if you are the only employee (and your spouse, in some cases). Both plans can be a solid choice for self-employed people. Before you decide, meet with a financial advisor who can help you build a custom financial plan.

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