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Choosing Between a SEP IRA and a Solo 401(k) – A Guide for Business Owners

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For U.S. sole proprietors and small business owners, choosing the right retirement plan can significantly impact their financial future. Two popular options are the Simplified Employee Pension (SEP) IRA and the Solo 401(k). Each offers unique benefits and features, making the choice between them dependent on individual circumstances and business goals. Business owners should remember that the SEP IRA must be offered to all employees, whereas the solo 401(k) is only for the business owner who has no employees. Here’s a detailed comparison to help you decide which plan is better suited for your needs.

business owner sep or 401k

Contribution Limits

SEP IRA

  • Employer Contributions Only: The SEP IRA allows employers to contribute up to 25% of an employee’s compensation, or $69,000 for 2024, whichever is less. This makes it an excellent option for business owners who want to maximize their retirement savings without dealing with complex contribution rules.
  • No Employee Contributions: Unlike other plans, employees cannot make their own contributions to a SEP IRA. All contributions come directly from the employer. Note that an employee can still contribute to their regular IRA or Roth IRA separate from the SEP IRA. Also, at a net income of $345,000 (2024), the SEP IRA business owner can maximize their annual contribution of $69,000 (2024) to their SEP IRA.

Solo 401(k)

  • Employee and Employer Contributions: The Solo 401(k) allows both employee and employer contributions. For 2024, the maximum employee contribution is $23,000 (or $30,500 for employees age 50 or older). The employer can also contribute up to 25% of compensation, with a combined total limit of $69,000 ─ or $76,500 for those aged 50 or older.
  • Higher Contribution Potential: Due to the combination of employee and employer contributions, Solo 401(k) plans often allow higher total contributions than SEP IRAs, especially for those who maximize both contributions.

Flexibility and Control

SEP IRA

  • Ease of Setup and Maintenance: SEP IRAs are known for their simplicity. They are easy to set up and maintain, with fewer administrative responsibilities and lower costs compared to other retirement plans.
  • : Employers are not required to contribute every year, providing flexibility based on the business’s financial performance.

Solo 401(k)

  • Loan Provision: One of the significant advantages of a Solo 401(k) is the ability to take a loan from the account. Participants can borrow up to 50% of their vested balance, to a maximum of $50,000. This feature can provide critical financial flexibility in times of need.
  • Roth Option: Solo 401(k) plans often include a Roth option, allowing after-tax contributions that grow tax-free, providing tax diversification for retirement savings.

Administrative Complexity

SEP IRA

  • Simple Administration: SEP IRAs are straightforward, with minimal administrative burden. There are no annual filing requirements for the employer, making it an attractive option for small business owners who prefer simplicity.

Solo 401(k)

  • More Complex Administration: While Solo 401(k)s offer more features, they come with increased administrative responsibilities. For example, if the plan’s assets exceed $250,000, the business owner must annually file a Form 5500 with the IRS.
  • More Record Keeping: Managing loans, Roth accounts, and ensuring compliance with contribution limits adds complexity, and requires more diligent record keeping.

Tax Considerations

SEP IRA

  • Tax-Deferred Growth: Contributions to a SEP IRA are tax-deductible for the business, and the funds grow tax-deferred until withdrawal, when they are taxed as ordinary income.
  • No Roth Option: All contributions are pre-tax, and there is no Roth option for tax-free withdrawals in retirement.

Solo 401(k)

  • Tax Deductible and Roth Contributions: Contributions can be pre-tax, reducing taxable income in the contribution year, or after-tax through a Roth Solo 401(k), providing tax-free withdrawals in retirement.
  • Tax Advantages for High Earners: The combination of tax-deferred and Roth contributions can offer significant tax planning advantages, especially for high earners looking to maximize their tax-advantaged savings.

Which Plan is Right for You?

Consider a SEP IRA if:

  • You prefer simplicity and ease of administration.
  • You have variable income and want the flexibility to adjust contributions annually.
  • You do not need the option for employee contributions or loans.

Consider a Solo 401(k) if:

  • You want to maximize your retirement savings with higher contribution limits.
  • You prefer having both pre-tax and Roth contribution options.
  • You may need to take a loan from your retirement savings.
  • You are willing to handle more complex administration and compliance requirements.

Conclusion

Both SEP IRAs and Solo 401(k) plans offer valuable retirement savings opportunities for business owners. The choice depends on your specific needs, income level, and preference for administrative simplicity versus flexibility and higher contribution limits. Consult with a financial advisor at Cardinal Point for personalized advice to ensure you select the plan that best aligns with your unique retirement goals and business strategy.