Solo 401(k) and SEP: Which is best for business owners?

When it comes to retirement planning, small business owners have a variety of options to choose from. Traditional or Roth IRA can provide a good start for retirement savings, but successful business owners usually need a plan that allows them to postpone more amounts each year.

SEP IRA was introduced to allow small business owners to set up retirement accounts for their businesses without worrying about the troubles caused by ERISA sponsored plans. However, subsequent financial legislation created a separate 401(k), which also provides a simplified way for business owners to save for retirement and enjoy some of the benefits of the 401(k) plan, which are not available in SEP of. Below are these two types of plans and how they meet the needs of small businesses.

Key points

  • Both SEP IRA and solo 401(k) allow small business owners to establish retirement accounts for their employees.
  • SEP IRA is funded only by employer contributions.
  • Solo 401(k) allows employers and employees to pay at the same time.

How the self-employed retirement plan works

SEP IRAs have been around for decades, and they may still be the easiest way for business owners to save for retirement. These plans are essentially pure profit sharing and allow owners to contribute to themselves and all eligible employees.

The amount that can be contributed is 25% of the highest business income-20% in the case of a sole proprietorship or single member limited liability company (LLC)-58,000 USD in 2021, 61,000 USD in 2022, whichever is lower allow.

One of the main advantages of SEPs compared to the strict reporting requirements imposed by qualified programs is that they are relatively simple, even those designed for self-employed people, such as the Keogh program.

The Solo 401(k) plan is a relatively new addition to the retirement planning community. These plans are designed for sole proprietorships with only one employee (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 individual practitioners than SEP IRA because it also provides the following features:

  • Employee extension: Unlike the SEP plan, a separate 401(k) allows participants to make separate employee contributions and profit sharing contributions. This allows the owner to contribute up to $19,500 to the 2021 plan and up to $20,500 to the 2022 plan, even if the business loses money during these years.
  • Catch-up contributions: A separate 401(k) allows the owner to provide the same amount as the SEP (see above restrictions), but it also allows participants aged 50 and above to make catch-up contributions for 2021 and 2022.
  • Roth donations: The Solo 401(k) plan allows Roth donations after tax, which allows owners to accumulate large amounts of tax-free funds over time. SEP IRA only allows traditional pre-tax contributions.
  • Loan regulations: The Solo 401(k) plan can allow participants to obtain loans equal to 50% of the plan balance or $50,000, whichever is less. The SEP program does not provide loans.

However, SEP IRA does allow employers to make retirement plan contributions on behalf of employees, although they are allowed to exclude part-time workers, people under 21, and people who have not worked for the employer for at least three years in the past five years.

The contribution limit is the same as the owner, except that it is the lesser of the dollar limit or 25% of the employee’s total compensation. The SEP IRA can also be established at any time before the business owner submits the tax return, and individual 401(k) donations must be completed before December 31 of the previous year to be included in the tax return.

Solo 401(k) and SEP IRA: main differences
Account type Employer contribution Employee contribution Catch-up contribution Ross contribution Loan provision Establishment requirements Operational requirements
Irish Republican Army Yes No No No No At any time before filing the tax return easier
Solo 401(k) Yes Yes Yes Yes Yes December 31 of the tax year Strict reporting requirements

(As of November 2021)

Which one should I choose? SEP IRA and Solo 401(k)

Today, small business owners have more choices when it comes to saving for retirement. Those with full-time employees can use SEP IRA to save for retirement, while solo practitioners can choose between it and a separate 401(k) plan with 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.

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