Individual 401(k) or SEP IRA: Which Is Better?

Working for yourself can be pretty great. As the boss, you can set the dress code at “jammies.” While you miss out on having a 401(k) plan set up for you (along with an HR department reminding you to make contributions), you can take care of those things pretty simply yourself. And you should, because as a self-employed worker, you have access to more and better retirement plan options than most people who are working for someone else.

Two of the most popular retirement savings accounts for the self-employed are individual 401(k)s, otherwise known as solo 401(k)s, and SEP IRAs. You’ve probably heard of both of these. Which is best for your situation?

How an Individual 401(k) Works

An individual 401(k) is a lot like the 401(k) offered by a traditional employer, but often better in terms of being able to sock away money. Why? Because you employ yourself, you get to make contributions as an employee and an employer.  

  • Just like your corporate working counterparts, you can make an employee contribution of up to $18,000 ($24,000 if you’re over 50).
  • Additionally, as an employer, you can contribute 20% of your net earnings from self-employment, as long as your total employer and employee contributions don’t top $54,000 ($60,000 if you are over 50).

For many individual 401(k) plans, you have the option of investing your employee contribution in a Roth 401(k). If you choose this, you do not get a tax deduction for your contributions. But when you take out the money for retirement, your withdrawals are tax-free. Having a source of tax-free income in retirement can be incredibly valuable. (For related reading, see: An Introduction to the Roth 401(k).)

You can make Roth contributions for your employee contribution, but not the employer portion. Having both Roth and regular options at play in your individual 401(k) gives you flexibility in your tax planning, now and in the future.

Mega Backdoor Roth Strategy

Less well-known is that some individual 401(k) plans allow you to make after-tax contributions, which can then be converted to a Roth. Typically you need to work with a professional to set up your individual 401(k) to allow for this, but for those looking to maximize their Roth contributions, it can be extremely worthwhile.

Here’s an example. Let’s assume you are under 50 and earn $100,000 as a self-employed worker.

Under the typical individual 401(k), as explained above, you start by making an $18,000 employee Roth 401(k) contribution. Then you add 20% of your net income to your regular 401(k) as your employer contribution. About half of your contribution is in Roth and half is not, and the total you put away is about $36,000.

With the mega backdoor Roth tactic, you still start by making your $18,000 employee Roth 401(k) contribution. Then, instead of making that employer contribution, you make use of your awesome self-employed benefits and make an additional $36,000 after-tax employee contribution. This not only gets you all the way to the $54,000 maximum, but you can convert the $36,000 after-tax contribution to a Roth IRA, bringing your total Roth contribution to $54,000. For those who seek to maximize their Roth accounts, this can be a fantastic retirement tool. (For related reading, see: Is a Backdoor Roth IRA Right for You?)

This isn’t the best solution for everyone’s self-employed retirement planning, of course. You’ll need to consider taxes, cash flow and your personal circumstances to see how this plays out each year and in the long run. A financial planner can be a great help with these decisions.  

Contributing to a SEP IRA

SEP IRAs allow you to make only the employer contribution portion. You can add 20% of your net earnings from the business, up to a maximum of $54,000 for 2017 (there are no over-50 catch-up provisions in a SEP). If you make at least $270,000, you can max it out. But if you earn less, you can sock more away in an individual 401(k).

What’s great about SEP IRAs is that you can set them up the day you file your taxes, including extensions. Individual 401(k)s, on the other hand, have to be set up by December 31 of the year for which you are claiming the deduction.

When it comes to retirement planning, as a self-employed worker, you really can have it better than your corporate friends. Even if you don’t wear pajamas or have a commute that’s just a walk down the hall.

(For more from this author, see: How to Give Tax-Saving Gifts Before the Year Ends.)