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Comparing Solo 401(k) and SEP IRA: Two Popular Retirement Plans for Self-Employed Individuals

Comparing Solo 401(k) and SEP IRA: Two Popular Retirement Plans for Self-Employed Individuals

May 21, 2024

For self-employed individuals, selecting the right retirement plan is crucial, as it not only helps to minimize taxable income but also enhances retirement savings. The Solo 401(k) and the Simplified Employee Pension (SEP) IRA are among the top choices due to their tailored benefits for self-employed professionals. This article provides an in-depth comparison of both plans, highlighting how compensation impacts contributions across different business structures and identifying which plan might be more advantageous depending on individual business needs. 


Solo 401(k) and SEP IRA: Key Features

Solo 401(k): This plan is designed specifically for business owners with no employees other than a spouse. The Solo 401(k) offers high contribution limits, allowing for both employee and employer contributions. For the year 2024, the employee contribution limit is $23,000 ($30,500 if age 50 or older), and the total contribution limit is $69,000 ($76,500 if age 50 or older).

SEP IRA: Although mostly adopted by businesses with self-employed owners only, this plan is also suitable for small businesses with a few employees. Contributions are made purely from employer funds, with limits up to 25% of each employee's compensation or a maximum of $69,000 for 2024. Unlike Solo 401(k)s, there's no catch-up contribution for older participants, and the employer contribution percentage must be the same for every eligible participant.


Withdrawals and Loans

Solo 401(k): Offers a loan feature, allowing you to borrow up to 50% of your account balance (maximum $50,000) without a tax penalty, which is not possible with a SEP IRA. Withdrawals before age 59½ generally incur a 10% penalty unless specific exceptions apply.

*You must pay back the loan in five years or less—unless it’s used to buy a primary residence, in which case you have up to 30 years. Just because you’re borrowing from yourself doesn’t mean it won’t cost you. You’re required to pay your account interest comparable to what you’d pay for a similar non-401(k) loan. You’ll also miss out on potential returns that money would have earned if it had stayed invested.

Early withdrawal rules for solo 401(k)s depend on which type of account you have. With a few exceptions, you must pay a 10% penalty tax on withdrawals from a traditional solo 401(k) account made before you turn 59 ½, plus income taxes on the amount withdrawn.

SEP IRA: No loan provisions are available in this plan. Early withdrawals also attract a 10% penalty, similar to the Solo 401(k).


Setup and Maintenance

Solo 401(k): The setup process is slightly more complicated and might require more paperwork than SEP IRAs. It also needs an annual report filing with the IRS if the account balance exceeds $250,000.

SEP IRA: This plan is known for its ease of setup and low maintenance. There's no annual filing requirement regardless of the account balance, making it less burdensome for the owner.


Flexibility

Solo 401(k): Provides greater flexibility for high-income earners to maximize their contributions because it allows for employee and employer contributions. Additionally, it includes a Roth option, where you can make after-tax contributions that grow tax-free, an option not available in SEP IRAs.

SEP IRA: While it doesn't offer a Roth option or allow for employee contributions, it's simpler to manage and can still provide significant retirement savings. 


Compensation and Contributions Across Business Entities

Determining compensation for the purposes of contributions to a Solo 401(k) or a SEP IRA depends significantly on the structure of the business entity. Here's how compensation is typically calculated for different types of entities such as S-Corporations, LLCs, Sole Proprietorships, and Partnerships.

  • Sole Proprietorships
    • Compensation Used: Net earnings from self-employment, which includes income after deducting business expenses and half of the self-employment tax.
  • Partnerships
    • Compensation Used: Net earnings from self-employment, like sole proprietorships. This includes the partner's distributive share of the partnership income or loss (after business expenses are considered), reduced by the entire amount of Section 179 expense deduction, and again adjusted for self-employment taxes.
  • S-Corporations
    • Compensation Used: W-2 wages from the S-Corporation to the owner. It's important that these wages are deemed reasonable compensation for the services provided to the corporation. Only the W-2 wages are considered for contributions, not dividends or other distributions.
  • C-Corporations
    • Compensation Used: Same as an S-Corporation, focusing on W-2 wages for contribution purposes. 
  • Limited Liability Companies (LLCs)
    • Compensation depends on the Tax Election from the four options listed above.

Contribution Deadlines

Solo 401(k):

  • For a sole proprietorship, partnership, or an LLC taxed as a sole proprietorship…
    • Employee salary deferral contributions can be deposited up to your personal tax filing deadline (April 15 plus extensions to October 15).
    • Employer profit-sharing contributions can be deposited up to your personal tax filing deadline (April 15 plus extensions to October 15).
  • For an S or C Corp, or an LLC taxed as a corporation…
    • Employee salary deferral contributions must be deposited as soon as reasonably possible after each W-2 pay period.
    • Employer profit-sharing contributions can be made up to the corporate tax filing deadline plus extensions (March 15 plus available extensions to September 15).

SEP IRA:

  • For a sole proprietorship, partnership, or an LLC taxed as a sole proprietorship…
    • Employer contributions can be deposited up to your personal tax filing deadline (April 15 plus extensions to October 15).
  • For an S or C Corp, or an LLC taxed as a corporation…
    • Employer profit-sharing contributions can be made up to the corporate tax filing deadline plus extensions (March 15 plus available extensions to September 15).

Higher Contribution Potential in Solo 401(k)

An important advantage of the Solo 401(k) is its dual contribution structure. For self-employed individuals with positive net earnings within certain ranges, the Solo 401(k) generally allows for greater total contributions compared to a SEP IRA. This is because the Solo 401(k) includes both elective deferrals (employee contributions) up to $23,000 (or $30,500 with catch-up contributions if 50 or older) and employer non-elective contributions up to 25% of compensation. This combination can result in a higher overall contribution limit, particularly beneficial for those with substantial earnings who wish to maximize their retirement savings.

Pay attention that the total contribution should not exceed your actual net earnings from self-employment after all deductions.

For example, if your net earnings before making Solo 401(k) contributions are only $10,000, then your adjusted net earnings after accounting for self-employment tax deductions will be $9,235. Thus, you can contribute up to $9,235, split between employee and employer contributions.

This also indicates no contributions can be made if the business has a net loss in the tax year.

Conclusion

Choosing between a Solo 401(k) and a SEP IRA involves considering your business structure, how compensation is calculated, and your specific financial and retirement planning needs. Consulting with a financial advisor can be invaluable in navigating these choices, ensuring that you maximize your retirement contributions while adhering to legal and tax requirements. Whether opting for the Solo 401(k)’s robust contribution allowances or the SEP IRA’s straightforwardness, the right plan will pave the way toward a secure financial future.