nest egg retirement

Solo 401(k) vs. SEP-IRA: What Business Owners Need to Know

nest egg retirement

Tax-advantaged 401(k) retirement savings plans are key benefits offered by companies to help workers build nest eggs for their post-employment lives. 

What happens, however, if someone chooses to start a smaller firm, or seeks a more entrepreneurial career as a self-employed worker? If you're a business owner or a self-employed worker, developing a tax-friendly 401(k) workplace retirement savings plan can prove to be a resource-intensive and time-consuming undertaking.

Alternatives do exist, however. Two popular options used by many business owners and sole proprietors allowed by the IRS are:

  • SEP-IRAs. This type of plan is formally referred to by the IRS as a "Simplified Employee Pension Plan." 

  • Individual 401(k) plans. These are commonly known as "Solo" 401(k) plans. 

Let's start with the basics. A SEP-IRA allows owners to make a 25% annual contribution based on their compensation. For a sole proprietor, it's 20% a year. The maximum contribution you can make for 2021 is $58,000. Another major difference to keep in mind: SEP-IRAs don't allow "catch-up" contributions for employees age 50 or older. That's a feature in 401(k) plans where such workers can contribute several thousand dollars more a year (up to $6,500 extra in 2021) to increase their overall yearly total. 

The SEP-IRA also limits contributions to pre-tax savings only, much like a traditional Individual Retirement Account (IRA) that employees can open separately (and in addition to) any workplace savings plan.

As a result, participants in SEP-IRA plans can't choose a post-tax (i.e., Roth) option. "In Roth-styled accounts, contributions aren't pre-tax upfront but the growth of principal over time is generally available to withdraw tax-free in retirement," says John Dahlin, head of IFA Taxes, a division of Index Fund Advisors. 

"These Roth accounts," he adds, "are a popular feature of corporate-sponsored 401(k) plans. But they're not an option for SEP-IRA retirement plan savers." 

Solo 401(k) plans typically offer the same maximum annual dollar contribution level as a SEP-IRA (not including catch-up contributions for those age 50 and over). In such a plan, the business owner essentially wears two hats in the eyes of tax authorities — one as an employee and another as an employer. This means that contributions can be made to the plan to cover both roles. According to the IRS, an owner can contribute both:

  • Elective deferrals up to 100% of compensation — considered as "earned income" in the case of a self-employed individual — up to the annual contribution limit:
    • $20,500 in 2022 ($19,500 in 2021), or $27,000 in 2022 ($26,000 in 2021) if age 50 or over, plus:
  • Employer nonelective contributions up to:
    • 25% of compensation as defined by the plan, or:
    • for self-employed individuals, the IRS says "you must make a special computation to figure the maximum amount of elective deferrals and nonelective contributions." Compensation is considered as earned income, which is defined as net earnings from self-employment after deducting both one-half of your self-employment tax and contributions for yourself.

Total contributions to a participant's account, not counting catch-up contributions for those age 50 and over, can't surpass $58,000 for 2021 and $61,000 for 2022, per the IRS.

"It's possible for a business owner to reach the same maximum contribution rates each year through a SEP-IRA," says Dahlin. "But his or her net income is going to need to be high enough to negate any advantage of the Solo 401(k) plan's profit-sharing feature." 

For individuals age 50 or older, Solo 401ks allow catch-up contributions for employees. In 2021, that can translate into an additional $6,500 per person in deferral contributions. Including savings opportunities in the profit-sharing portion of the plan will increase the maximum for such workers to $64,500. (In a SEP-IRA for 2021, the maximum contribution amount was $58,000 a person, regardless of age.) 

Business owners should keep in mind that SEP-IRAs can be initiated up to most tax extension deadlines, points out Dahlin. On the other hand, he notes that individual 401(k) plans need to be established by Dec. 31 in order to make contributions for that tax year.

"With its greater flexibility in terms of timing," says CPA Dahlin, "a SEP-IRA can be set up to retroactively make a contribution that will reduce the owner's taxable income for the prior tax year."

As noted above, a key feature to remember for business owners looking to use a Solo 401(k) plan is that they've got to set it up before the calendar year's end. "People need to look closely at their own unique financial and tax planning situation," says Dahlin. "One size doesn't fit all when you're trying to choose the best retirement plan for yourself or your workers."

This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There are no guarantees investment strategies will be successful.  Investing involves risks, including possible loss of principal. This is intended to be informational in nature and should not be construed as tax advice. IFA Taxes is a division of Index Fund Advisors, Inc.

Certified Public Accountant (CPA) is a license to provide accounting services to the public awarded by states upon passing their respective course work requirements and the Uniform Certified Public Accounting Examination.