Solo 401k or SEP IRA – Best Retirement Plan for Self-Employed

Solo 401(k) - Retirement Planning for Self-Employed

Solo-K vs. SEP IRA: Which is better for Self-Employed?

Solo 401k SEP IRARecently, I’ve had quite a few consultations with new clients looking to open Solo 401k Plans. They are solo entrepreneurs (aka “solopreneurs”) and they want to discuss what options they have to save for retirement. Most people are familiar with SEP IRAs (Simplified Employer Pension Individual) but not with Solo K Plans even though they have been around for 20 years. After numerous discussions, I thought it was time to write a post about it. If you’re a small business owner with no employees (spouses do not count) a Solo K might be a good option to help you save for your retirement.

Why is a Solo 401k important to consider?

Studies show us that too many self-employed small business owners don’t save enough for retirement. This is a mixture of:

  • being so busy running your business (hey, that’s a lot of work!),
  • cashflow management – When business is good, you might opt to keep cash on hand in case business slows down. And the years go by and you have very little saved. I have seen this all too often.

What Is a Solo 401(k)?

A solo 401(k) is a retirement plan designed for individual business owners or self-employed. The idea was to give small businesses the same advantages of a large company 401k for a fraction of the annual fees. A Solo 401(k) will work for sole proprietors, independent contractors, and freelancers. The key thing to know, no employees (besides spouse).

Retirement Plan for the Gig Economy

As the gig economy grows, I noticed that a few of the conversations were with individuals who have a W-2 job (“the day job”) but also have a side-hustle. In that case, they may be able to contribute to both. However, I advise them to double-check with a tax professional. I don’t offer tax advice. I help my clients get the Solo 401(k) plan setup, build an investment portfolio, and figure out how much they should invest each year to pursue their stated retirement goals.

One consult was for a 65-year-old with lots of energy and still working. He thought he wasn’t eligible because of his age. Guess what? There are no age or income restrictions when it comes to a solo 401(k).

With a Solo 401(k) retirement plan, you have two ways to invest:

  1. Traditional 401(k) – This works just like a Traditional IRA in that you get a tax deduction for what you contribute. Then when you retire and withdraw from the 401k, you’ll owe taxes on your contributions and whatever earnings you had.
  2. Roth 401(k) – You probably have heard of the Roth IRA and this is similar, but I think it’s much better. The Roth IRA is limited to only $6,000 in annual contributions in 2020 and 2021 (plus catch up of $1,000). But check this out. You can contribute $19,500 to the Roth 401k in 2021 (and another $6,500 for catch-up). And you get the same tax advantages like the Roth IRA, in that earnings are tax-free when you withdraw them.
    • And the cherry on top is there is no disqualification if your income is too high. As a result, I have higher-income clients contributing $26,000 per year to their Roth 401k and they would be disqualified from contributing to the Roth IRA because they make too much money.

Solo 401(k) vs. SEP IRA: Which one is better for self-employed?

Here’s an overview of how the Simplified Employer Pension (SEP IRA) works

  • This is an employer contribution only and it is calculated as a max contribution up to 25% of your net earnings.
  • There is only a pre-tax (AKA Traditional) option (this is because it is an employer contribution).
  • The SEP IRA is a pretty simple account to set up.
  • CPAs seem to love SEP IRAs and I often see that as their recommendation. I think that stems from ease of setup and CPAs are more familiarity.
  • Lastly, if you do employ others, you must make a contribution for them as the employer.

Differences between SEP IRA and Solo 401(k):

  • Catch-up contributions are not allowed with a SEP IRA. The reason is that it’s funded via employee contributions. This is a BIG drawback.
  • SEP contribution is based on a % of earnings but with a Solo K, you can contribute $19,500 (plus $6,500 if 50 years or older) as an employee as long as you earn at least that much. So in essence you could contribute your first $19,500 of earnings. Then you can contribute another amount as the employer. In my experience, I find that clients are able to contribute more to a Solo K annually than a SEP IRA. So if your goal is contribute more towards retirement, then this is an important point to consider.

Tax Advantages of the Solo 401(k)

As I mentioned earlier, the Solo 401(k) allows you to choose traditional or Roth (or both) each year and there’s no income disqualifications.

Here’s a breakdown of what contributions are possible:

  • Salary deferral contributions. These are the contributions that you made from your salary. And if your spouse is on the payroll (for example $19,500), she can contribute that entire amount too.
  • Catch-up contributions. If you’re over 50, then this would be any additional money you put into the plan up to limit ($6,500 in 2020 and 2021).
  • Employer contributions. There are the funds that your company contributed to the plan on your behalf.

Maximum contributions allowed for Solo 401(k) Plan in 2021:

  • $57,000 total annual 401(k) contribution limit if you are age 49 or younger (that’s a LOT of tax advantages!)
  • $63,500 total annual 401(k) contribution limit if you are age 50 or older

The Solo 401(k) is certainly an exciting option for self-employed individuals. But there is a lot to consider.

So book a consultation and we’ll find the appropriate option for you.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.