As a small business or as the sole employee of your company, navigating your financial future can be intimidating. Setting up a retirement savings account through a brokerage is complex. But how can you make the decision between a solo 401(k) vs SEP IRA without one?

Let’s take a closer look at how these two different retirement accounts work and solutions to find the best fit for you.  

What is a Solo 401K?

Perhaps the main difference between a SEP vs solo 401(k) is the ability to contribute to your retirement savings. While both allow the employer to contribute, only the solo 401(k) allows the employee to make contributions to the account. If you are the only employee at the company and intend to stay that way, you can contribute up to the maximum of $20,500 in 2022. This is no different than a regular 401(k) account.

Additionally, as you are also the employer, you have the option of matching contributions up to 25% of income to the business up to an account value of $61,000.

What is a SEP IRA?

With a SEP IRA, it is all about employer contributions. Even if you have a standard 401(k) at your day job, you can also enroll in a self-employed IRA if you are working a side hustle. An employer can contribute up to 25% of the annual income in 2022 for a maximum contribution of $61,000.

Keep in mind that this is still an IRA and will stick to the rules of this investment. You will not be able to pull money out early without penalties (10% penalty tax). The money in the account will also grow tax-deferred until the time when you withdraw distributions from the account.

Solo 401(k) vs SEP IRA: Key Differences

Now that you know the basics of these two distinct types of retirement accounts, it’s time to take a closer look at which one you want to choose as a self-employed individual.

Employer Contributions

If you plan to hire employees for your business, you might want to think long and hard about how much of the income you contribute to a SEP IRA. Business owners must make the same contributions to every employee in the company.

This means that you will have to match whatever you are paying yourself into the SEP IRA. That means a larger team can put a huge dent in the bottom line if you are currently maxing out your personal contributions at the 25% income limit. Both a solo 401(k) and SEP IRA max contributions at $61,000.

Contribution Rates

While the contribution limits are similar with both a solo 401(k) and a SEP IRA, most people are able to save more rapidly with a 401(k). The SEP IRA allows employees to save 25% of their income whereas a solo 401(k) allows them to contribute as much as they want, up to the annual limit.

Once the limit on your solo 401(k) has been reached ($20,500 for 2022), you have the option of making employer contributions at 25%–up to the maximum limit allowed.

The way the 25% actually works is that it limits the amount of contribution to 20% of wages. For example, if someone earns $100,000 in self-employed wages, they get a deduction on their pay. Thus, if they contribute 20% of their pay, that would be $20,000 as an employer contribution.
This reduces their pay from $100,000 to $80,000 or 25%.

It’s important to remember that you are allowed to contribute more under the Solo(k) than the SEP IRA.

For example, a Soloprenuer earns $100,000 in income in 2022.

SEP IRA

• Employer Contribution Maximum = $20,000 (Compensation is decreased to $80,000 after the deduction from taxes)
• No employee contributions or Catch-Up Contributions are allowed under a SEP.
• Employees may also establish a Traditional IRA and are allowed to make personal contributions up to $6,000 plus an additional $1,000 for those 50 or older.
• A Roth IRA may also be established, but the total limits for the IRA may not be exceeded (the $6,000 is a combined limit between Traditional and Roth).
• Maximum contributions between a SEP and setting up additional IRA accounts = $26,000 (or $27,000 if 50 or over).

Solo 401(k)

• Employer Contribution Maximum = $20,000 (Same as above)
• May also contribute $20,500 of employee contributions.
• May contribute an additional $6,500 if age 50 or over.
• Employee contributions may consist of Pre-Tax or Roth or a combination.
• Maximum contributions allowed for a Solo(k) plan = $40,500 (or $47,000 if age 50 or over).

So, while the SEP and the Solo 401(k) plan essentially have the same limits, in true practical applications, the Solo(k) allows for much more flexibility in determining savings for retirement.

Catch-Up Contributions

Did you start out saving for retirement late in the game and want to catch up now? You have a couple of options depending on how you structure your retirement savings. A Solo 401(k) allows you to contribute an additional $6,500 if you are over age 50.

A SEP IRA does not allow for catch-up contributions. However, you can contribute more to your traditional or Roth IRA which is separate from the SEP IRA. This generally requires an additional account to be set up and maintained. Retire4one has all the accounts (Employee Pre-Tax Deferrals, Employee Roth Deferrals, and Employer Contributions all in one location, and all in one account. You can contribute all types at one stop.

Roth Contributions

With a solo 401(k), you can make Roth contributions that are taxed going into the account and can be withdrawn in retirement tax-free. This is great if you think that you will be in a higher tax bracket in retirement than you are right now.

It’s also another reason to choose the Solo(k) over the SEP IRA. As an individual, you can set up an IRA or Roth IRA, but the limits are much lower and the Solo(k) allows for Roth contributions and conversion to Roth of employer contributions.

If you choose to invest instead through a SEP IRA, you do not have the option of making Roth contributions. Instead, you will want to hope that you are at a lower income in retirement than you are right now for this to make the most sense financially.

Paperwork

Unfortunately, there is often some confusion around when it comes to the nomenclature of Solo 401ks. There are many interchangeable names for the Solo 401k, which can (understandably) cause some confusion for those looking to set up a Solo 401k. Try not to let all of the different names confuse you though, at the end of the day, all of them are referencing the same one-participant 401k plan. 

A Simple, Effective Solution

Solo 401(k) vs SEP IRA management is important to consider. The paperwork that you must keep up with can be challenging for a Solo 401(k) but is relatively simple for a SEP IRA. However, Retire4one’s process is much easier than setting up a SEP IRA, Traditional IRA, or Roth IRA.