SEP IRA vs Solo 401(k): Which is Right For You?

When it comes to retirement planning, self-employed individuals and small business owners have several options to choose from. Among the most popular are the SEP IRA (Simplified Employee Pension Individual Retirement Account) and the Solo 401(k). Each of these retirement vehicles offers unique benefits and rules, and understanding them can help you make an informed decision about which plan best suits your needs. This article will break down the essentials of SEP IRAs and Solo 401(k)s, provide a comparison between the two, and discuss the possibility of having both types of accounts.

A SEP IRA (Simplified Employee Pension Individual Retirement Account) is a retirement plan designed for self-employed individuals and small business owners. It allows employers to make contributions to their employees’ retirement savings, including their own if they are self-employed.

In a SEP IRA, only the employer (or self-employed individual) can make contributions. Employees cannot contribute to the plan. Contributions are made to individual retirement accounts (IRAs) set up for each eligible employee. The contribution amount can vary each year, giving the employer flexibility depending on business performance.

For 2024, the contribution limit for a SEP IRA is the lesser of 25% of an employee’s compensation or $69,000. For self-employed individuals, the contribution limit is calculated based on net earnings from self-employment, after deducting half of the self-employment tax and the SEP contribution itself. This effectively results in a limit of 20% of net earnings.

Technically, the SECURE 2.0 Act allows for Roth SEP IRA plans. However, there has yet to be a provider of Roth SEP IRAs due to clarity required from the IRS. Once a Roth SEP IRA is actually available, contributions can be made with after-tax dollars, allowing for tax-free withdrawals in retirement.

SEP IRA funds are subject to the same withdrawal rules as traditional IRAs. Withdrawals made before age 59½ are subject to a 10% early withdrawal penalty, in addition to ordinary income tax. Withdrawals after age 59½ are taxed as ordinary income.

Like traditional IRAs, SEP IRAs are subject to Required Minimum Distributions (RMDs) starting at age 73. RMDs are calculated based on the account balance and the account holder’s life expectancy.

A Solo 401(k), also known as an Individual 401(k), is a retirement plan specifically for self-employed individuals or business owners with no employees (other than a spouse). This plan offers the opportunity to contribute as both an employer and an employee, potentially maximizing retirement savings.

In a Solo 401(k), both the employer and the employee can make contributions to the plan. Employees cannot contribute to the plan.

Solo 401(k) plans also offer a Roth option, where employee contributions are made with after-tax dollars, allowing for tax-free withdrawals in retirement. Employer contributions must still be made with pre-tax dollars.

Withdrawals from a Solo 401(k) are subject to the same rules as traditional 401(k) plans. Withdrawals before age 59½ are subject to a 10% early withdrawal penalty and ordinary income tax on pre-tax contributions and earnings. Roth Solo 401(k) withdrawals can be tax-free if the account has been open for at least five years and the account holder is at least 59½.

Solo 401(k) accounts, like SEP IRAs, are subject to RMDs starting at age 73. However, Roth Solo 401(k) accounts must also follow RMD rules, unlike Roth IRAs.

When comparing SEP IRAs and Solo 401(k)s, several key differences stand out:

SEP IRAs only allow employer contributions, while Solo 401(k)s allow contributions as both employer and employee. This dual contribution structure in Solo 401(k)s often allows for higher total contributions, especially for those under age 50.

Solo 401(k)s offer a Roth option, providing flexibility for tax planning. SEP IRAs do not have a Roth option actually available at the moment, but that could change in the future because of the provisions in the SECURE 2.0 Act.

SEP IRAs can be offered to employees, making them a viable option for small businesses with employees. Solo 401(k)s are only available to self-employed individuals with no employees (except a spouse).

Administrative Complexity: Solo 401(k)s require more paperwork and annual filings, especially when plan assets exceed $250,000.

No Employees Allowed: The plan is only available to self-employed individuals with no employees (except a spouse), limiting its applicability for small businesses with employees.

Yes, it is possible to have both a SEP IRA and a Solo 401(k), but there are important rules and requirements to consider:

Contributions to both accounts are subject to the overall IRS contribution limits. For 2024, the total contribution limit (for SEP IRA and Solo 401(k) combined) is $69,000, or $76,500 if you’re eligible for catch-up contributions.

If you have both accounts, your employer contributions to a Solo 401(k) and a SEP IRA must be coordinated, as they are subject to the same contribution limit.

Managing both accounts can add administrative complexity, as each account has its own rules, reporting requirements, and tax implications.

Deciding between a SEP IRA and a Solo 401(k) can be complex, especially when considering factors like contribution limits, tax treatment, and administrative requirements. It’s essential to evaluate your specific financial situation, business structure, and retirement goals before making a decision. Consulting with a financial advisor or tax professional can provide personalized guidance to help you choose the retirement plan that best aligns with your needs.

Whether you choose a SEP IRA, a Solo 401(k), or both, the key is to take proactive steps to secure your financial future. Retirement planning is a long-term commitment, and having the right strategy in place can make all the difference in achieving your retirement goals.