Maximizing Your Retirement: SEP IRA vs Solo 401k

February 22 , 2024

Planning for retirement is a crucial element of ensuring your financial security, especially if you’re self-employed or a business owner. Your retirement strategy isn’t just about saving money for your golden years; it involves making the right decisions to maximize your savings and tax advantages. Two widely-used options for individuals in this category are the SEP IRA and the Solo 401(k).

In this article, we’ll dive into the key features and benefits that distinguish these two retirement plans. These distinctions go beyond technical details and encompass contribution limits, tax advantages, and investment flexibility. Understanding these differences can significantly impact your retirement planning.

Our objective is to provide you with a comprehensive comparison of SEP IRA and Solo 401(k) plans, enabling you to make an informed decision tailored to your unique financial situation and retirement goals. As we explore the specifics, you’ll gain valuable insights to help you determine which plan best aligns with your individual financial objectives and retirement aspirations.

What is SEP IRA and What is Solo 401(k)

Now, let’s take a closer look at each of these retirement plans: the SEP IRA and the Solo 401(k). We’ll start by understanding what each plan entails, how they work, and what makes them distinct in the realm of retirement planning.

SEP IRA (Simplified Employee Pension Individual Retirement Account)

A SEP IRA, or Simplified Employee Pension Individual Retirement Account, is a retirement plan designed for self-employed individuals and small business owners. This plan allows you to make contributions for yourself and your employees, if you have any. It’s relatively easy to set up and maintain, making it an attractive option for those who want a straightforward retirement savings vehicle.

Solo 401(k) (Individual 401(k) or Self-Employed 401(k))

A Solo 401(k), also known as an Individual 401(k) or Self-Employed 401(k), is another retirement plan tailored for self-employed individuals or business owners with no employees, except for a spouse working in the business. This plan offers the advantage of both employer and employee contributions, potentially allowing for higher total contributions compared to a SEP IRA. It provides greater flexibility in managing your retirement savings, including a wider range of investment options.

In the following sections, we will delve deeper into the specific features and differences between these two retirement plans to help you make an informed choice based on your financial needs and goals.

Key Differences Between SEP IRA and Solo 401(k)

Although both SEP IRAs and Solo 401(k) plans are retirement options designed for self-employed individuals and business owners, they have distinct features and benefits. The key differences between these two plans lie in their contribution limits, tax benefits, and investment flexibility – aspects that can significantly impact your retirement savings strategy.

1. Contribution Limits:

• SEP IRA: In 2023, the maximum contribution limit for a SEP IRA was $66,000. However, in 2024, it increased to $69,000.
• Solo 401(k): In 2023, the Solo 401(k) offered a maximum contribution limit of $66,000 or $73,500 for individuals aged 50 or above, including both employee deferrals and employer contributions. In 2024, the limit increased to $69,000, with an additional catch-up contribution limit of $7,500 for individuals aged 50 or above.

2. Tax Benefits:

• Solo 401(k): Provides several tax advantages, including tax-deferred growth of investments and tax deductible contributions. If chosen, the Roth Solo 401(k) option allows for tax-free withdrawals during retirement, subject to specific conditions.
• SEP IRA: Offers tax benefits, such as tax deductible contributions and tax deferred growth, but doesn’t provide the Roth option, limiting the flexibility of tax-free withdrawals.

3. Contribution Sources:

• SEP IRA: Contributions solely come from the employer and are based on employee compensation. For self-employed professionals, contributions depend on net business income.
• Solo 401(k): Allows personal contributions as an employee in addition to employer contributions, potentially resulting in higher total contributions.

4. Investment Options and Flexibility:

• Solo 401(k): Offers a wide range of investment options, including real estate, precious metals, tax liens, and more, providing greater flexibility in diversifying your retirement portfolio.Additionally, Solo 401(k) participants have the option to take out loans against their accounts, a feature not available with SEP IRAs.
• SEP IRA: Generally offers a narrower selection, including stocks, bonds, ETFs, and mutual funds. It may not provide as much diversity as a Solo 401(k).

When choosing between a SEP IRA and a Solo 401(k), it’s crucial to consider these key differences. The Solo 401(k) often stands out for its higher contribution limits, flexible tax options, and broader investment choices. In contrast, SEP IRAs offer simplicity and employer-focused contributions. Assess your unique financial situation and retirement goals to determine which plan aligns best with your needs. Consulting a financial advisor can also provide personalized guidance to make an informed decision.

Pros and Cons of SEP IRA and Solo 401(k)

Now that we’ve covered the basics of SEP IRAs and Solo 401(k) plans, let’s delve into their respective advantages and disadvantages. Both options offer unique benefits, but they also have certain drawbacks. Your decision between the two should align with your specific financial situation, income, tax considerations, and retirement savings objectives.

Pros of a SEP IRA:

• High Contribution Limit: In 2023, you could contribute up to $66,000, offering a significant opportunity for retirement savings. In 2024, this limit increased to $69,000, providing even more potential for building your retirement nest egg.
• Easy Setup and Administration: SEP IRAs are easy to establish and maintain.
• Compatibility with Other IRAs: You can combine a SEP IRA with a traditional IRA or a Roth IRA.
• Contribution Limit: Contributions, including those made for employees, are tax-deductible. Deductions are capped at the lesser of $69,000 ($66,000 for 2024) or 25% of compensation (subject to the compensation cap in the given year).
• Flexibility: You are not obligated to contribute every year, providing financial flexibility.
• Employer Flexibility: SEP IRAs allow employers to make proportional contributions for eligible employees.

Cons of a SEP IRA:

• No Catch-Up Contributions: Savers aged 50 or older do not have the option for catch-up contributions.
• Required Proportional Contributions: Employers must make proportional contributions for each eligible employee if they contribute for themselves.
• Required Minimum Distributions: Like traditional IRAs, SEP IRAs require minimum distributions starting at a certain age (e.g., age 73 from 2023 onwards).
• Early Withdrawal Penalties: Distributions before age 59½ are taxed as income and subject to a 10% penalty, unless they qualify for an early withdrawal exception.

Pros of a Solo 401(k):

• Dual Contributions: A Solo 401(k) permits both employee and employer contributions, maximizing your retirement savings potential. This flexibility allows you to contribute from both sides, increasing your ability to save for retirement.
• Contribution Limits: In 2023, you could contribute up to $66,000. Starting in 2024, the contribution limit increased to $69,000. Additionally, individuals aged 50 or older can make extra catch-up contributions. This means that in 2023, those aged 50 or older could contribute up to a total of $72,500 ($66,000 + $6,500), and in 2024, they can contribute up to $76,500 ($69,000 + $7,500) to their Solo 401(k) plans.
• Spousal Participation: If your spouse works with you, they can also contribute to a Solo 401(k), potentially allowing couples to invest over $100,000 in retirement accounts.
• Loan Option: You can borrow up to 50% of your plan value or $50,000 from your Solo 401(k), with a repayment period of up to five years (or potentially 30 years for a home purchase).

Cons of Solo 401(k) Plans:

• Complexity and Administrative Requirements: Setting up and managing a Solo 401(k) plan can be more complex and may involve additional administrative tasks compared to simpler retirement options like IRAs.
• Employer-Only Plan: Solo 401(k) plans are designed for self-employed individuals without employees, except for a spouse working in the business. This limits eligibility, and if you have non-spousal employees, other retirement plans may be more suitable.
• Required Minimum Distributions (RMDs): Similar to SEP IRAs, Solo 401(k) plans also require minimum distributions once you reach a certain age.
• Early Withdrawal Penalties: Like most retirement accounts, taking distributions before age 59½ may result in income tax and a 10% penalty, unless you meet specific early withdrawal exceptions. This can restrict access to your funds before retirement.

Eligibility and Choosing the Right Plan

When selecting the right retirement plan, eligibility criteria become crucial. Both the SEP IRA and Solo 401(k) come with specific requirements based on your employment status and business structure.

For SEP IRA eligibility, individuals must be at least 21 years old, have a work history of at least 3 of the last 5 years with the employer, and have earned a minimum of $750 in compensation. This plan extends its accessibility to a variety of individuals, including self-employed professionals and small business owners with employees.

Eligibility for a Solo 401(k) is more specific. It mandates that you derive income from a sole proprietorship or a business operated solely by you or in conjunction with your spouse. Additionally, you should be a business owner with no employees, except for your spouse. There are no limitations based on age or income, but it’s important to note that your spouse is considered an employee for Solo 401(k) eligibility.

Moreover, the selection of an appropriate retirement plan depends on various factors. These considerations encompass your current income, future tax bracket, business growth plans, and desired retirement savings. For example, if you have a high income, a Solo 401(k) may offer opportunities for larger contributions and increased tax deductions. Additionally, it’s crucial to factor in future tax brackets since withdrawals from retirement accounts are taxed as ordinary income. If you anticipate being in a higher tax bracket at retirement, a Roth Solo 401(k) may be a better option.

Additional Retirement Planning Tips

Once you’ve established your retirement plan, it’s essential to focus on your overall retirement strategy. Creating a SEP IRA or Solo 401(k) is just the beginning. Here are some key considerations:

1. Diversify Within Your Solo 401(k) or SEP IRA

While Solo 401(k)s and SEP IRAs are robust retirement savings tools, it’s also wise to diversify within these accounts. Diversification means spreading your investments across various asset types to reduce risk. Within your chosen retirement plan, explore different investment options such as stocks, bonds, mutual funds, and other assets that align with your risk tolerance and long-term goals.

2. Leverage Roth Options

If your Solo 401(k) or SEP IRA provider offers Roth sub-accounts, consider taking advantage of them. Roth contributions are made after-tax, and qualified withdrawals in retirement are tax-free. Having both pre-tax and Roth funds within your retirement account can provide valuable flexibility when managing your tax liability in retirement.

3. Understand RMD Rules for Each Plan

For both Solo 401(k)s and SEP IRAs, it’s crucial to understand the rules regarding Required Minimum Distributions (RMDs). These are the minimum amounts you must withdraw annually from your retirement accounts once you reach a certain age. Familiarize yourself with the specific RMD rules for your plan type to avoid penalties and ensure proper planning.

4. Stay Informed About Contribution Limits

Keep up to date with the annual contribution limits for your Solo 401(k) or SEP IRA. These limits can change from year to year, and staying within the allowable contribution limits is essential for maximizing your retirement savings while adhering to IRS regulations.

5. Regularly Review and Adjust Your Strategy

Retirement planning is dynamic and requires ongoing attention. Regularly review and adjust your contributions as your income levels change or as you approach retirement. Consider life events, market fluctuations, variations in income, and shifts in your financial goals when making adjustments. Maintaining flexibility and adaptability in your retirement strategy will help ensure it stays aligned with your evolving needs.

Start Your Retirement Planning Today

SEP IRAs and Solo 401(k)s both present valuable retirement planning opportunities for you, each with its own set of advantages and considerations. The decision between the two depends on your specific financial circumstances and your aspirations for retirement. We encourage you to take proactive steps towards your retirement.