SEP IRA vs Solo 401k Plans – Eligibility, Max Contribution Limits & More

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There are a lot of advantages that come with being self-employed. There are also a lot of responsibilities that you must consider, including saving for your retirement. Employers might offer you a 401k plan that allows you to make contributions, which you can then rollover into new plans if you find a different job.

When you’re self-employed, you become your own boss. That means you must start your own retirement plan, then fund it.

Two popular products are available in the United States to help this process get started. If you own a business or you are self-employed, a SEP IRA or a Solo 401k plan might be good options to consider, so you can start saving for your retirement.

What Is a SEP IRA?

SEP stands for “simplified employee plan.” If you own a business, then your employees do not make contributions to this individual retirement account. The contributions for each employee must match the percentage of the salary that owners make for themselves.

For that reason, a 401k plan might be a better option for those who have employees working for them.

Here are some of the primary features that are associated with a SEP IRA.

1. The business makes the contributions to this IRA. Employees do not make contributions.

2. The contributions made to a SEP IRA are considered a business expense.

3. The contributions are capped at 25% of the compensation given to the employee. For those who are self-employed, there may be Schedule C ramifications of this contribution to consider.

4. Self-employed business owners can contribute up to 20% of their net income.

5. The contributions are also capped at $55,000.

6. Most major custodians that work with the self-employed or small business owners provide access to a SEP IRA.

7. A SEP IRA can be opened and funded up until the day you file your tax return, which includes extensions from the prior year.

There is no Roth option available with a SEP IRA, so you will want to take a look at your income qualifications before deciding on this retirement option. Some small business owners or self-employed individuals may find tax advantages available to them with other IRA options.

You cannot take a loan from your SEP IRA either.

You do have the option of skipping contributions if your business happens to have a bad year. You are just stuck following the contribution rule. You must match the level of compensation that you give yourself with the SEP IRA with what you give to your employees. There is no minimum contribution.

Most investment options that are available through other IRAs are also available to SEP IRA accounts.

Must custodians charge an annual holding fee for a SEP IRA, which can be as high as $2,000 for those pursuing specialty investments. Trades have individual fees to consider and there may be ETF and mutual fund expense ratios charged.

What Is a Solo 401k Plan?

Solo 401k plans, which are also sometimes called an individual 401k or a self-employed 401k, allows for employee and employee contributions. As with the SEP IRA, you will find that most major custodians allow for this type of retirement plan. You may just find that the rules may vary a little, depending upon the custodian that you choose.

These are the primary features of the solo 401k plan that you will want to consider.

1. This plan is available to the business owner, a spouse involved with the business, or partners in a business only. Employees who fall outside of these categories are not allowed to participate in a solo 401k plan.

2. Employee salary deferrals are permitted with this retirement option, including employee profit-sharing contributions which occur.

3. The current limit for the solo 401k plan is $18,500 per year for employee deferrals, with an additional $6,000 per year in catch-up funding permitted for those who are 50 or older during any point of the tax year.

4. When all forms of contributions are considered for this retirement option, total contributions cannot exceed $55,000 for those under 50. They cannot exceed $61,000 for those who are 50 and over.

5. The investment options for a solo 401k are usually the same as any other IRA or brokerage account, but some custodians do have restrictions.

To be able to take a deduction for the current tax year, the solo 401k must be opened before December 31. Salary deferrals and employer profit-sharing is usually permitted up until the day you file your tax return, including any permitted extensions. Some variation does occur based on the structure of the business, so it may be necessary to consult with a professional tax advisor to discuss your options.

You do have the option for loans and a Roth with a solo 401k, but custodians may have restrictions in place. Before opening the retirement account, confirm all the rules that are applicable to your situation.

There are some government filing requirements you will need to follow with this plan, but those do not usually start until the balance in the solo 401k reaches $150,000.

SEP IRA vs Solo 401k: Which Is the Better Option?

Although there are some similarities to consider between the SEP IRA and the solo 401k plan, there are some key differences which must be evaluated as well. There is not a one-size-fits-all plan that you’re going to find.

For most people, opening a SEP IRA tends to be the easiest option. You can start the plan up to the date your return is filed for the previous year, which includes extensions. There is more paperwork for the solo 401k plan, but the timing is pretty much the same as well.

If you have a SEP IRA, then the percentage of compensation calculation which is used for contribution caps might lower your overall contribution amount. Even if you have the cash available to make larger contributions to the plan, current rules may prohibit you from doing so.

The SEP IRA does not currently permit any catch-up contributions for those who are 50 or older either.

With the solo 401k plan, your primary restriction is the total amount of income that you generate while self-employed or owing your small business. As long as you exceed the annual limits, you are permitted to contribute the full amount. If you make less than the full annual limit during the year, you’re still permitted to contribute the full amount of what you earned.

For those wanting to save a lot for their retirement in a short amount of time, the solo 401k plan tends to be the best option. That is especially true for those who have an unpredictable income.

High-income earners who have consistency with their annual wages may opt for the SEP IRA instead.

For those who have the income to qualify for a Roth plan, the tax advantages of doing so may be the superior option to consider. Because Roth retirement plans use after-tax income, you are able to grow your account, then withdraw tax-free at a qualifying age under most circumstances.

The custodian fees for a solo 401k plan are typically lower than that of a SEP IRA, ranging from $25-$50 annually. Trading commissions also apply, as do ETF and mutual fund expense ratios. If you choose to borrow against your 401k, then you may have loan underwriting fees to consider as well.

A Final Thought About the SEP IRA and Solo 401k Plan

When you run a small business, or you earn income through self-employment, it can be easy to lose sight of your retirement. You’re focused on getting your work done and making sure that you’re bills are paid. That’s understandable.

You also don’t have the advantage of a human resources department finding these retirement plans for you, then reminding you to send in the paperwork, so you can sign up for them.

That doesn’t mean you should ignore saving for your retirement. There is no reason you can’t be putting a little money away each month.

No matter which plan you decide is right for you, either the SEP IRA or the solo 401k plan, or even another type of retirement savings option altogether, it is still important to make sure you perform your own research. Be diligent about review the rules from each custodian.

Then talk with a financial expert you trust and weigh all your choices before making a final decision about which retirement plan is right for you.