Solo 401(k) vs. SEP-IRA: Key Differences for Self-Employed Investors

According to a QuickBooks survey in collaboration with Gallup, as many as 44 million workers reported being self-employed at some point during any given week in 2019. But that number has jumped significantly with the growing popularity of side hustles and with the impact of the COVID-19 pandemic. With so many Americans now responsible for their own work benefits, self-employed workers are left with the decision to pick an appropriate retirement plan. This often means choosing between a Solo 401(k) vs. a SEP-IRA.

Not sure which retirement plan is right for you? Read on to learn about the key differences between these investment options.

Solo 401(k) vs. SEP-IRA: The basics

Solo 401(k)s and SEP-IRAs are available to entrepreneurs, small business owners, including freelancers and independent contractors. But each plan has distinct advantages and disadvantages when comparing the two investment options.

Here’s a quick breakdown of the key differences between a SEP-IRA vs. a 401(k) for 2024.

Now, let’s take a deeper look at a Solo 401(k) vs. SEP-IRA.

What is a SEP-IRA?

A SEP-IRA, short for Simplified Employee Pension Individual Retirement Account, is available to any business with one or more employees.

Although it has the word “pension” in its name, it’s not a defined benefit plan. Instead, a SEP-IRA functions similarly to a personal IRA (e.g. Traditional or Roth IRA) in terms of receiving favorable tax benefits. For example, you can benefit from tax-deductible SEP-IRA contributions and tax-free growth.

But unlike with a personal IRA account or a Solo 401(k), a SEP-IRA is established by the business entity. So, only the employer is permitted to make contributions.

Employees aren’t allowed to make their own elective contributions. But self-employed individuals can make contributions as the employer to their own account. This is the case even if you’re a sole proprietor or one-person LLC without other employees.

This is a huge perk considering SEP-IRA plans come with a higher contribution limit.

For the 2024 tax year, an employer can contribute the lesser of either 25% of the employee’s compensation or $69,000. Depending on your income, this could be significantly more than a personal IRA, which has an annual limit of $7,000 (or $8,000 if you’re at least 50 years old).

Other noteworthy SEP-IRA features include:

• The IRS requires you to contribute the same percentage of compensation to all employees as you contribute to your own.
• Employer contributions (including contributions to your own account) are fully tax-deductible up to certain IRS limits, which means you’ll receive a dollar-for-dollar tax break in taxable income.
• Employees are always 100% vested in all contributions made to a SEP-IRA.

SEP-IRAs are generally easy to establish and operate compared to traditional employer-sponsored retirement plans. Most major brokerages offer this retirement option with the ability to open it online.

What is a Solo 401(k)?

A Solo 401(k) is sometimes referred to as an individual 401(k), a one-participant 401(k) or Solo-k. It has the same rules as a traditional 401(k), but it’s designed for self-employed individuals with no eligible employees. However, a spouse might be eligible to contribute to a Solo 401(k) if they work for the business.

Depending on your income, a Solo 401(k) might provide you with an opportunity to make higher annual contributions and take advantage of bigger tax deductions.

Similar to a SEP-IRA, an employer can contribute up to 25% of the employee’s compensation. If you don’t pay yourself W-2 wages, your maximum contribution has an adjusted calculation that works out to roughly 20% of your net earnings. Consult IRS Publication 560 for the exact deduction limit formula.

But unlike a SEP-IRA, the employee can also opt to make elective deferrals up to $23,000 in 2024. Plus, individuals aged 50 and over can make additional catch-up contributions up to $7,500 annually.

However, total contributions to a Solo 401(k) account cannot exceed $69,000 for 2024, excluding catch-up contributions.

Example for Solo 401(k)

For example, let’s say Peter is self-employed with $100,000 in business net profits and is under the age of 50. According to The Fidelity Self-Employed 401(k) Contribution Worksheet, he could make up to $41,087 in contributions for 2024. This includes contributing $18,587 as the employer and $22,500 as employee contributions.

If Peter were at least 50 years old, he could make an additional $7,500 catch-up contribution. This would max out his permitted retirement contributions at $48,587.

Other noteworthy Solo 401(k) features include:

• A Solo 401(k) gives you the choice to make post-tax Roth contributions, an option that isn’t available with a SEP-IRA.
• If your spouse is employed by your business, you can potentially double your overall household retirement savings since their 401(k) will be subject to its own annual limits separately.
• If you have another employer that offers a 401(k) plan, your elective deferrals combined can’t exceed the annual contribution limit of $23,000.

These types of retirement calculations can be complicated, so it’s best to consult a tax accountant for guidance.

What type of investor benefits from a SEP-IRA vs. a 401(k)?

Let’s look at a few scenarios that may help you decide which retirement option is best for your situation when weighing a Solo 401(k) vs. a SEP-IRA.

Investor Scenario 1: You’re a freelancer, independent contractor or sole proprietorship

If you have no intention of expanding your business to include other employees, then it’s up to you to decide whether you want to invest in a SEP-IRA vs. a 401(k).

If you’re a high earner, you’ll likely benefit more from a Solo 401(k) since it allows for a greater contribution and tax deduction benefit. However, SEP-IRAs are generally easier to set up and more accessible than the process to establish a Solo 401(k).

Investor scenario 2: You plan to hire an employee at some point

If you plan to have an employee in the future (other than your spouse), then it’s probably better to go ahead and choose a SEP-IRA now. Once you hire someone, you’ll no longer have the option to use a Solo 401(k). So, you can avoid the hassle of transitioning to an eligible retirement plan in the future by going with a SEP-IRA from the get-go.

Investor scenario 3: You want to max out your retirement savings at the highest level

Solo 401(k) vs. SEP-IRA options have similar maximum contribution limits from the employer side. But a 401(k) allows you to also make contributions as an employee. It also provides a catch-up contribution for older adults.

You’ll have the option to make much larger annual contributions under a Solo 401(k). This can significantly boost your savings rate.

Investor scenario 4: You prefer to make after-tax contributions

If you think you’ll be in a higher tax bracket come retirement — or if you just prefer to make after-tax contributions in general — then it makes sense to go with a Solo Roth 401(k). You’ll pay income tax on your elective contributions as an employee now and receive tax-free withdrawals in retirement.

Other retirement options for self-employed people

We covered two popular choices, Solo 401(k) vs. SEP-IRA. But there are also other retirement plan options to explore.

In most cases, you can still contribute to a Roth or Traditional IRA even if you have a Solo 401(k) or SEP-IRA. In fact, anyone with earned income (including W-2 wages) is eligible to invest in their own personal IRA.

If your business has a fairly large team, you might benefit more from providing a SIMPLE IRA or SIMPLE 401(k) plan. These retirement options are intended for businesses with less than 100 employees.

Once you’ve nailed down the best retirement plan for your situation, you can start making smart investments on your own with guidance from Student Loan Planner’s Six-Figure Debt to Six-Figure Net Worth investment course.