Small business owners have several options to choose from when it comes to retirement planning. SEP IRAs were introduced as a way to let small business owners establish retirement accounts for their businesses. Financial legislation created the Solo 401(k), which also offers a simplified way for business owners to save for retirement and enjoy some of the benefits of an employer-sponsored 401(k) plan.
A self-employed business can open a SEP IRA and a Solo 401(k) plan and contribute to both plans. Both are tax-deferred retirement strategies. The SEP-IRA allows individuals to save up to 25% of their income into the account. With a solo 401(k), individuals can save up to 100% as an employee contribution, up to the annual dollar threshold, and also gain employer contributions of up to 25%.
- SEP IRAs and solo 401(k)s both allow small business owners to establish retirement accounts for their employees.
- SEP IRAs are funded by employer contributions alone.
- Solo 401(k)s allow both employer and employee contributions.
SEP IRA vs. Solo 401(k)
SEP IRAs have been around for decades, and they are probably still the simplest way for business owners to save for retirement. These plans are purely profit-sharing in nature and allow owners to make contributions for themselves and all eligible employees.
The amount that can be contributed is the lesser of up to 25% of business revenue—20% in the case of a sole proprietorship or a single-member limited liability corporation—or a set dollar amount adjusted for inflation every year ($61,000 for 2022 and $66,000 for 2023.)
One of the main advantages of SEPs is their relative simplicity compared with the rigorous reporting requirements that come with qualified plans, even those that are designed for self-employed persons, such as Keogh plans.
SEP IRAs do allow employers to make retirement plan contributions on behalf of employees, though they are allowed to exclude part-time workers, those under age 21, and those who have not worked for the employer in at least three of the previous five years.
Contribution limits are the same as for the owner, except that it is the lesser of the dollar limit or 25% of the employee’s total compensation. SEP IRAs can also be established at any time before the business owner files a tax return.
Solo 401(k) plans are a relatively recent addition to the retirement plan community. These plans are designed exclusively for sole proprietorships that have only one employee (the owner). Also known as an “individual” or “self-employed” 401(k) plan, this type of retirement savings account is generally considered a better option for solo practitioners than a SEP IRA because it also offers the following features:
- Employee deferrals: Unlike SEP plans, solo 401(k)s allow participants to make a separate employee contribution as well as a profit-sharing contribution. This allows the proprietor to contribute up to $20,500 to the plan for 2022 and $22,500 for 2023, even if the business loses money in those years.
- Catch-up contributions: A solo 401(k) allows the same amount to be contributed by the owner as a SEP (see limits above), but it also allows participants who are age 50 and above to contribute an additional $6,500 for 2022 and $7,500 for 2023 as catch-up contributions.
- Roth contributions: Solo 401(k) plans allow for post-tax Roth contributions, which can allow the owner to accumulate a substantial pool of tax-free money over time. SEP IRAs only allow traditional pretax contributions.
- Loan provision: Solo 401(k) plans can allow participants to take out a loan equal to the lesser of 50% of the plan balance or $50,000. Loans are not available with SEP plans.
Solo 401(k) contributions must be made by Dec. 31 of the previous year to be counted on the tax return.
|Solo 401(k) vs. SEP IRA: Key Differences|
|Account Type||Employer Contribution||Employee Contribution||Catch-Up Contributions||Roth Contributions||Loan Provision||Establishment Requirement||Operational Requirements|
|SEP IRA||Yes||No||No||No||No||Anytime before filing tax return||Relatively simple|
|Solo 401(k)||Yes||Yes||Yes||Yes||Yes||Dec. 31 of the tax year||Rigorous reporting requirements|
Which Should I Choose?
Owners of small businesses have more choices today when it comes to saving for retirement. Those who have full-time employees can save for retirement using a SEP IRA, while solo practitioners can choose between that and a solo 401(k) plan that has higher contribution limits and other advantages.
For more information on retirement plans and accounts, download Publications 575, 590-A, and 590-B from the IRS website, or consult your financial advisor.
Internal Revenue Service. "401(k) Plans for Self-Employed Individuals - Fact or Fiction?" Page 2 of PDF.
Internal Revenue Service. "One-Participant 401(k) Plans."
Internal Revenue Service. "SEP Contribution Limits."
Internal Revenue Service. "SEP Plan FAQs."
Internal Revenue Service. "Choosing a SEP-IRA Plan."
Internal Revenue Service. "Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans)," Page 6.
Internal Revenue Service. "Retirement Plans for Self-Employed People."
Internal Revenue Service. “401(k) Limit Increases to $22,500 for 2023, IRA Limit Rises to $6,500.”
Internal Revenue Service. "Retirement Plans FAQs on Designated Roth Accounts."
Internal Revenue Service. "Retirement Topics - Plan Loans."
Internal Revenue Service. "401(k) Resource Guide - Plan Participants - General Distribution Rules."
Internal Revenue Service. "About Publication 575, Pension and Annuity Income."
Internal Revenue Service. "About Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs)."
Internal Revenue Service. "About Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs)."
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