SEP IRA vs. Solo 401(k): Which Retirement Plan is Right for You?

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What Is a SEP IRA?

A SEP IRA is a retirement plan that can be established by any employer, including self-employed individuals. Authorized by Congress in 1978, SEP IRAs have been around longer than solo 401(k)s. Setting up a SEP IRA is straightforward. Once you select a provider, typically a bank, credit union, or investment brokerage, you’ll be guided through an easy setup process.

Your investment choices may be somewhat limited, typically including traditional options like stocks or mutual funds rather than cryptocurrency, metals, or insurance. For self-employed individuals, the maximum contribution for 2023 is either 25% of your net compensation or $66,000, whichever is less. As of 2023, SEP IRAs can also be offered as Roth IRAs, where taxes are paid on current income, in addition to traditional, tax-deferred IRA contributions.

SEP IRAs do not offer catch-up contributions for those over 50 because they are fully funded by the employer. If your business grows and you hire employees other than a spouse, your SEP IRA can cover those employees, provided your guidelines for eligibility are no stricter than those set by the IRS. However, you must contribute the same percentage of compensation to employee accounts as you do to your own.

Pros of SEP IRAs

• Easy setup
• Potentially larger contributions than traditional or Roth IRAs
• Relatively low administrative and maintenance costs
• Can be set up as late as the day taxes are due (including extensions) for your business

Cons of SEP IRAs

• Loans from your saved funds aren’t available
• No catch-up contributions
• Employee contributions not permitted

What Is a Solo 401(k)?

A solo 401(k) is similar to a 401(k) plan offered by a business but is designed for one-person businesses or one person and a spouse. Created as part of the Economic Growth and Tax Reconciliation Relief Act of 2001, solo 401(k)s can be either traditional (tax-deferred) or Roth.

There are two basic requirements for a solo 401(k): self-employment activity and the absence of any employees other than a spouse. You can make contributions as both the employer and an employee up to a maximum of $66,000 for 2023. Additionally, if you are at least 50 years old, you may be eligible for a catch-up contribution. Note that if you also contribute to a 401(k) plan through a W-2 employer, overall maximums apply to individuals, not accounts.

Pros of Solo 401(k)s

• Potentially higher contribution limits
• Flexible contributions
• Ability to contribute in the next calendar year (to shelter income from taxes)
• Can be set up to allow borrowing from the account

Cons of Solo 401(k)s

• Typically more complicated and expensive setup
• Higher maintenance costs
• Cannot be used if you hire additional employees
• Required reporting to IRS once your account reaches $250,000

Should You Choose a SEP IRA or a Solo 401(k)?

Many financial experts recommend a solo 401(k) because it may allow you to shelter more income from taxes. You can also borrow from a solo 401(k) plan. However, its administrative costs and tax reporting requirements may be greater than those for a SEP IRA. And if your business grows, a solo 401(k) is no longer allowable.

The Bottom Line

Self-employed individuals are responsible for their own retirement savings. There are tax-advantaged ways to save, and it’s not a one-size-fits-all situation. Consulting a financial planner about the best way to save if you’re self-employed is advisable. Regardless of the retirement savings vehicle you choose, developing the habit of setting money aside is crucial for your financial health.

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