Individual 401(k) Plan: The Top Retirement Vehicle for Sole Proprietors

There are very few slam dunks in retirement planning, but choosing an individual 401(k)—also known as a one-participant 401(k) or solo 401(k)—over a SEP IRA can be one of them. If you are a sole proprietor and want to maximize your retirement contributions with the lowest cost and the most flexibility, check out these five reasons why an individual 401(k) might be right for you.

1. Maximum Pretax Contributions

A key advantage of the individual 401(k) is that the maximum amount you can contribute is higher at every level of net earnings than for a SEP IRA. The chart below shows the maximum contributions you could make at varying income levels and illustrates that the difference between the two can be considerable.

For example, at $50,000 of net earnings, a person 50 or older can contribute as much as $42,500 to an individual 401(k). This contribution amount for 2023 includes:

• The maximum individual contribution of $22,500 (up from $20,500 in 2022)
• The catch-up contribution for those 50 and over of $7,500 (up from $6,500 in 2022)
• The additional 25% of overall compensation ($12,500)

By comparison, the SEP IRA allows a self-employed business owner to set aside up to 25%, which in this example would be just $12,500. That is a $30,000 difference in favor of the individual 401(k).

The table below shows that individual 401(k) maximum contributions continue to exceed those of the SEP IRA until net earnings reach $264,000—the difference is still in favor of the individual 401(k) up until compensation reaches $263,999.99. These maximums assume that you're eligible for the catch-up provision (for anyone age 50 and older), which will allow you to contribute an additional $7,500 to a 401(k) in 2023 (up from $6,500 in 2022); the SEP IRA has no catch-up provision.

The individual 401(k) beats the SEP IRA for the maximum plan contribution regardless of your net earnings—unless you're a very high earner. For sole proprietors living in states with high income-tax and those with additional outside sources of income, this could mean the difference between a refund and a bill when it comes time to do your taxes. Moreover, because this difference will occur each year, it can put hundreds of thousands of extra dollars in your retirement plan throughout your career.

2. Contributions Are Discretionary; Loans Are Allowed

Individual 401(k) contributions are not mandatory every year. This allows sole proprietors to manage their cash flows and contribute the maximum amount in good years while contributing less or nothing at all if their business takes a turn for the worse. In addition, owners may be able to take loans for as much as $50,000 or 50% of the value of the benefits in the plan (whichever amount is lower).

Although the SEP IRA doesn't require mandatory contributions, it has no such loan provisions. The ability to take a tax-free loan from your individual 401(k) in the case of an emergency should be taken seriously because sole proprietors often have variable incomes from year to year.

3. Ease, Low Cost, and Flexibility

Individual 401(k) accounts are easy to open and manage. If you open one at a discount broker, you may incur practically no costs other than those included in trading. They are also highly flexible when it comes to investing. In addition, you are not required to file Form 5500 with the Internal Revenue Service, provided your plan contains less than $250,000 worth of assets. This is true for both individual 401(k) plans and SEP IRA plans.

4. Less-Expensive Roth Conversions

Another notable advantage of the individual 401(k) is that, unlike the SEP IRA, it is not considered in determining the pro-rata cost for a Roth conversion.

Suppose you have a SEP IRA with $100,000 and a traditional IRA with $75,000 ($30,000 of which represents nondeductible contributions). If you convert your total traditional IRA worth $75,000, you would only be able to exclude roughly 17% ($30,000 / $175,000) of the conversion from your ordinary income. This is because the IRS requires you to prorate the nondeductible contributions across your entire IRA balances, including the SEP IRA.

Now, let's say that instead of having the SEP IRA, you have an individual 401(k) with $100,000, plus the traditional IRA with $75,000. Again, $30,000 of that amount represents nondeductible contributions. If you convert your total traditional IRA worth $75,000, you could exclude 40% ($30,000 / $75,000) of the conversion from ordinary income, as the individual 401(k) is not included in the pro-rata calculation. In both situations, you are converting $75,000 to a Roth IRA, but with the individual 401(k), you pay less in taxes today because you are only recognizing $45,000 ($75,000 x (1 – 0.40)) compared to the example with the SEP IRA, in which you would have recognized $62,250 ($75,000 x (1 – 0.17)) in taxable income.

You could even take this a step further and move all of the pretax money from the traditional IRA to the individual 401(k). Then you would have $145,000 in the individual 401(k) and $30,000 in your traditional IRA, of which 100% would represent nondeductible contributions. In this case, it is possible to convert the $30,000 traditional IRA and exclude 100% of the conversion from ordinary income, making it an essentially tax-free Roth conversion.

5. The Option to Elect Roth Contributions

If you are in a low tax bracket today and would prefer to pay the taxes now, you can elect to have the employee salary deferral portion of your 401(k) contributed after-tax into a Roth individual 401(k). The employer must still contribute before tax as with a traditional Individual 401(k). The SEP IRA does not have this option.

The Bottom Line

In many cases, the individual 401(k) is a better alternative to the SEP IRA for sole proprietors. If you are accustomed to making annual contributions to a SEP IRA, note that the deadline to open an individual 401(k) is Dec. 31, as opposed to the SEP IRA, which you have until April 15—or an adjusted tax day because of a weekend—of the following year to fund.