Solo 401(k) vs. SEP IRA: Which is Best for the Self-Employed Individual?
You have successfully survived the start up of your business, and you're now making some money. You know what that means? Business Taxes! One of the best tax strategies for entrepreneurs is funding retirement accounts for retirement planning. Although there are lot retirement plans to consider, let's look at two popular options, the Solo 401(k) and the SEP IRA and their key differences.
Table of Contents
What is a SEP IRA?
What is a Solo 401k aka Individual 401(k)?
Maximum Contribution Limits (2023)
Investment Options
Employee Contributions
Roth Option
Example 1
Example 2
What is a SEP IRA?
SEP IRA stands for Self Employed Pension Individual Retirement Arrangement. For businesses that file as a Sole Proprietorship (Schedule C), self-employed business owners can lower their business income by contributing 20% of their net income (subject to self employment tax) up to $61,000 (2023). The dollar limit is adjusted annually to keep pace with inflation. For other business entity types (S-Corporations), the annual contribution limit is 25% of wages up to $61,000 (2023).
Pros:
No business size limit
No Filing requirements for the plan
No required contributions
Can exclude employees under 21 or paid less than $650(2022) in a year
Can exclude union employees
Can exclude employees who haven't worked in at least three of the last five years
Cons:
Contribution is a percentage of wages (or taxable income subject to
Contribution is a percentage of wages (or income subject to
What is a Solo 401k aka Individual 401(k)
Although technically a Solo is a 401(k) there are limitations compared to a "regular" 401(k). The primary being that you can only have yourself, as a self-employed person, and your spouse as an employees. If you have any other employees, you must follow the rest of the rules for a 401(k). You and your spouse can contribute two ways in a 401(k), as an eligible employee and as an employer. As an employee, you can contribute 100% of your W-2 wage up to $20,500 (2023), $27,000 (2023) if you are 50 or over, the so called catch-up provision.
Pros:
No filing requirement for plans with less than $250k (form 5305-EZ for plans in excess of $250k)
Salary deferral
Employee Loan Option
ROTH Option
Cons:
Filing requirement when assets exceed $250,000.
Download our retirement planning comparison report
Contribution Limits (2023)
SEP IRA Contributions Limits
Employer Contribution: 25% of wages up to $61,000/
Employee Contribution: N/A
401k Contributions Limits
Employer Additional Contributions: 25% of wages. Combined employer and employee contributions are limited to 100% of wages or $61,000.
Employee Contribution: 100% of wages up to $20,500 ($27,000 if employee is 50 or over, the additional catch-up contribution). These are voluntary contributions by the employee.
Investment Options
When it comes to retirement savings plans, you want as many investment options as possible. Generally, SEP and 401k plans are subject to the same range of investment options.
Employee Contributions
With a 401k, employees are required to make a salary deferral election. This percentage of compensation is limited to 100% of the employee's salary or $20,500.
Under a SEP, employees do not make any contributions.
Roth Option
One of the key benefits of a 401k vs SEP IRA is the ability to establish a Roth Option. In a 401k you can make contributions to a Roth account with the same limitations as a regular 401k account. Unlike an individual Roth IRA, there is no income limitation on participating in your 401k's Roth provision. Additionally, there is not restriction on making an individual Roth IRA contribution if you participate in a 401k, unlike with a traditional IRA.
This means that, subject to income limitations, you can contribute the maximum to your individual Roth IRA account AND fully fund your Roth 401k account. Double winning!
Although there is no tax deduction and therefore don't receive any tax benefit for contributions to a Roth (post-tax Roth contributions), the investments grow tax deferred, and under current law, distributions from your Roth are tax-free withdrawals. For younger taxpayers, this is ideal. Lastly, Roth accounts have no required minimum distributions as traditional IRA's do.
Comparison Example 1
Let's assume you have no employees other than yourself, and you have an S-Corporation. You take a wage of $50,000 each year and have another $50,000 in profit after your salary. Here is what you could contribute to each:
SEP IRA
25% of your $50,000 W-2 Wages = $12,500
Solo 401(k)
100% of your W-2 Wages up to limit = $20,500
25% of your W-2 Wages as employer = $12,500
Total contribution = $33,000
Comparison Example 2
Now let's assume that you are sole proprietor (Schedule C) and you make the same $100,000 as above. Here is that the contributions would look like:
SEP IRA
20% of your $100,000 income subject to self employment tax = $20,000
Solo 401(k)
100% of your W-2 Wages up to limit = $20,500
25% of your W-2 Wages as employer = $12,500
Total contribution = $33,000
Conclusion
In most cases, for the small business owner, a Solo 401(k) is a better option than a SEP. Consult with your tax and financial advisor to review your situation. Fortunately, at Core we're BOTH. Let us help you reach your financial goas.
