Solo 401(k) vs. SEP IRA: A Comprehensive Guide for Freelancers and Entrepreneurs

Key Highlights

• Solo 401(k) has higher contribution limits.
• Solo 401(k) offers loan options.
• SEP IRA suitable for businesses with employees.

Solo 401(k) vs. SEP IRA: Which is Best for Freelancers and Entrepreneurs?

Choosing the right retirement plan is crucial for securing financial stability in your later years, especially for freelancers and solo entrepreneurs who don't have access to employer-sponsored plans. With numerous options available, it's essential to understand which plan aligns best with your financial goals and business structure. Two popular choices for self-employed individuals are Solo 401(k) plans and SEP IRAs. Each offers unique benefits and features, making them suitable for different types of business owners. This guide will help you compare these plans to determine which one is the best fit for you.

What is a Solo 401(k)?

A Solo 401(k) is a retirement plan designed specifically for self-employed individuals and small business owners with no employees, other than a spouse. It combines features of a traditional 401(k) and allows for significant contributions.

Definition and Eligibility:

• A Solo 401(k) is a qualified retirement plan for self-employed individuals or business owners with no full-time employees, except for a spouse.
• Eligible individuals include sole proprietors, partnerships, and corporations.

Key Features:

• Contribution Limits: You can contribute as both employer and employee, allowing for higher contribution limits. For 2023, you can contribute up to $66,000, or $73,500 if you are over 50, including catch-up contributions.
• Tax Advantages: Contributions are tax-deductible, and you can choose between pre-tax (traditional) and after-tax (Roth) contributions.
• Flexibility: The plan allows for loans up to 50% of the account balance, with a maximum of $50,000.

Best For:

• Freelancers and self-employed individuals who want to maximize their retirement savings and benefit from higher contribution limits and tax advantages.
• Any freelancer making less than $276,000 in pay in 2024 wants to maximize their retirement tax-shelter.  
• Any freelancer that wants to take advantage of 60+ Catchup contributions
• Freelancers that want the ability to take a loan from their retirement plan. 

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What is a SEP IRA?

A SEP IRA (Simplified Employee Pension Individual Retirement Account) is a retirement plan that allows business owners to make tax-deductible contributions to their own and their employees' retirement savings.

Definition and Eligibility:

• A SEP IRA is a retirement plan established by employers, including self-employed individuals, to provide retirement benefits for themselves and their employees.
• Any employer with one or more employees, or self-employed individuals, can set up a SEP IRA.

Key Features:

• Ease of Setup: SEP IRAs are easy and inexpensive to set up and maintain, with minimal paperwork.
• Contribution Limits: Employers can contribute up to 25% of each eligible employee's compensation, with a maximum of $69,000 for 2024 ($66,000 in 2023). Contributions are made solely by the employer.
• Employee Coverage: Contributions must be made for all eligible employees, which includes those who are 21 or older, have worked for the employer in at least three of the last five years, and received at least $650 in compensation during the year.

Best For:

• Small business owners with employees who want to provide a simple benefit to their employees and aren’t looking to maximize their retirement savings/tax benefits.    

Comparison of Solo 401(k) and SEP IRA

Solo 401(k) allow you to save more:

Solo401(k)s allow many solo entrepreneurs to save more because they allow you to make both employee contributions (up to 100% of your pay) and company contributions (capped at 25% of eligible pay).  SEP-IRA’s don’t allow you to make $50+ Catchup contributions.    

To see how valuable the employee contributions are, let’s assume that Jane made $190,000 in eligible pay in 2024.  Here is how it would work out: 

Higher Solo401(k) contribution limits = More tax Savings:

The primary reason Solo 401(k)s are often the best from a tax-perspective is that they allow entrepreneurs to save more 

Solo 401(k)’s are more flexible than SEP IRAs:

• Solo 401(k): Allows loans up to 50% of the account balance (max $50,000) and catch-up contributions for those over 50.
• SEP IRA: Does not allow loans or catch-up contributions.

Common Questions Answered

What is a Solo 401(k)? A Solo 401(k) is a retirement savings plan designed for self-employed individuals and small business owners with no full-time employees, other than a spouse.

How to Open a Solo 401(k)? To open a Solo 401(k), choose a plan provider, complete the necessary paperwork, and establish the plan by December 31st of the tax year. Ensure you meet eligibility requirements and understand the contribution limits.

Are Solo 401(k) Contributions Tax-Deductible? Yes, contributions to a Solo 401(k) are tax-deductible, reducing your taxable income for the year. Roth contributions, however, are made with after-tax dollars but offer tax-free growth and withdrawals.

Can I Have Both a Solo 401(k) and a Regular 401(k)? Yes, you can have both, but the total employee contributions to both plans cannot exceed the annual limit ($23,00 for 2024, or $30,500 if over 50). Employer contributions are separate and subject to different limits.

Conclusion

Choosing between a Solo 401(k) and a SEP IRA depends on your business structure and retirement goals. A Solo 401(k) is ideal for high-income freelancers looking to maximize savings and take advantage of higher contribution limits and loan options. In contrast, a SEP IRA is better suited for small business owners with employees, offering a simpler and more cost-effective solution. Assess your financial situation, consult with a financial advisor, and choose the plan that aligns best with your long-term retirement objectives.

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