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Comparing the SEP IRA vs Solo 401k for the Self-Employed

Self-employment can offer an excellent work-life balance, as well as other freedoms and lifestyle benefits! Hahaha…wasn’t that funny. Seriously though, self-employment will likely be the cause of you working 70-80 hours a week…ha! This obviously leaves a ton of time to research the SEP IRA vs Solo 401k.

This picture really captures the "alone-ness and fear" one can feel contemplating the Sep IRA vs Solo 401k
This picture really captures the “alone-ness and fear” one can feel contemplating the Sep IRA vs Solo 401k.

The plus side of this, however, is that you often enjoy putting in the hours because it’s “your company,” and you’ll be the one benefitting from any “windfall of money” your long, long hours create–so good work! Keep it up.

And because you are so “boss” and independent and whatnot, you also take on the responsibility of your own retirement plan–which you should DEFINITELY HAVE.

Why Do I Need a Retirement Plan?

1) You Need Money to Stop Working

Obviously, you need to save money for your eventual retirement, and (in my opinion) a more hopeful “Act 3″ (of a 4 Act Life), otherwise known (by me) as a down-shift or semi-early-retirement.

2) To Reduce Your Taxes

This point is almost even more important than point #1. You need to utilize your retirement plan to help reduce your taxes, so you can have more money to put into #1. It’s a little bit of a chicken/egg thing I suppose.

So Where Do I Start?

Naturally, the financial industry has provided a host of confusing products, the research of which will probably result in your procrastination. So, I’m going to boil it down for you, and compare two standard products: the SEP IRA vs Solo 401k.

OK, I’m just going to cut to the chase–if your company is just you and/or your spouse, go with the Solo 401k. But keep reading to see why…

-Joe Disanto

Just to be clear, this post is mostly meant to compare each of these retirement plans for the purpose of someone who is self-employed and does not have employees, except for a spouse. Mainly because a Solo 401k (as the word “solo” indicates) is for an individual person. A traditional 401k would accommodate someone with employees.

It’s also worth noting that in the case of both retirement plans, the employer (you) and employee (you) have to set up accounts associated with the plan. So the employer creates the pension plan, and then the employee has a “participant” account.

The Most Significant Distinctions Between the SEP IRA vs Solo 401k

The term IRA stands for “Individual Retirement Account,” one of the two most standard retirement accounts that any individual can have. A SEP IRA stands for “Simplified Employment Plan” IRA. It’s a retirement plan that is intended for businesses, and allows participation by owners and employees.

A 401k is the other most common retirement account, but is more commonly known as a plan available to employees through their job. A Solo 401k (also can be referred to as an individual 401k or self-employed 401k) is available to business owners and their spouses (if involved in the business). Partners and other employees are not permitted to participate in the plan. Employer profit sharing contributions are allowed, as are employee salary deferrals.

Both the SEP IRA and Solo 401k are available through most significant custodians (aka brokerage houses) and can be opened and funded up until the date you file your tax return. Fidelity, for example, offers all of these products and has a nice comparison chart on their site.

What Are the Most Important Questions to Ask About the SEP IRA vs Solo 401k?

1. Is it Just You (and Your Spouse) or Do You Have Employees?

SEP IRA – While this type of account can be utilized if you have a smaller amount of employees, I would not recommend it in that case. It is however a relatively easy-to-setup option for a “sole-owner-employee” business.

Solo 401k – This type of account is available to business owners and their spouse only (if involved in the business). Partners and/or other employees are not permitted to participate in the plan. So basically, if you have partners or employees, you can’t have this plan.

2. What Are the Contribution LIMITS for the SEP IRA vs Solo 401k (and Even More Significant…Contribution TYPES)?

SEP IRA – With this type of account, only the employer (you) can profit share (aka contribute) to the employee’s (you and your spouse’s) accounts, up to 25% of the total annual W2 income. This includes a max of 56K per employee. And similar to the Solo 401k, you can effectively sock away a combined 112K of tax deferred income. That’s kind of insane.

Solo 401k – With this type of account, the employees (you and your spouse) can have pre-tax contributions taken from your W2 paycheck up to 19K/year (in 2019). PLUS, the employer (you) can profit share (aka contribute) to the employee’s (you and your spouse’s) accounts, up to 25% of the total annual W2 income. This caps at a total collective contribution limit of 56K per employee. So, if you wanted to max it out, you can effectively sock away a combined 112K of tax deferred income, to help minimize your tax owed. That’s kind of insane.

THIS NEXT PART IS IMPORTANT!

You are probably now saying to yourself…”well shit…the SEP IRA and Solo 401k sound very much like the same thing.” Not quite. There is an important distinction here, one that will produce much greater tax benefit overall. Because of the way the contributions can be made, you can defer much more income with far less W2 pay, utilizing the Solo 401k. See here…

With 24K of W2 pay, the Solo 401k can create a 24K deduction, while the SEP IRA only allows for a 6K deduction.

In the example above, using only 24K of W2 pay, the Solo 401k can create a 24K deduction! At this same W2 pay, the SEP IRA only allows for a 6K deduction. HUGE difference.

Additional Important Questions Regarding the SEP IRA vs Solo 401k

1) When Can I Withdraw Money?

A “must-ask” when considering what type of account to invest in, is when you can access your funds, and whether there will be substantial penalties imposed should you require access earlier than anticipated. The rules are fairly similar for both accounts.

SEP IRA – With a SEP IRA, an employee can access their funds and make a withdrawal at any time after the age of 59½. However, withdrawing money from a SEP IRA will still be subject to the relevant federal income taxes and, if under the age of 59½, the employee may be subject to a 10% penalty.  

Solo 401k – You cannot take withdrawals from the plan until a “trigger” event occurs, such as turning age 59½, disability, and/or plan termination. But as your own employer, you could terminate yourself. Just like with a SEP, withdrawals would be subject to the relevant federal income taxes and, if under the age of 59½, may be subject to a 10% penalty.  

2) Can I borrow from the funds?

SEP IRA – In short, NO! IRS rules state that you cannot “borrow” from an IRA. A “distribution” from an IRA may be permissible. However, this is not a loan, and the transaction is irreversible. Furthermore, IRAs cannot be used as collateral when applying for a loan.  

Solo 401k – In short, YES! Loans are admissible with this plan. Each plan participant (you and your spouse) can borrow up to 50K, over a 5 year time period.

However, it’s important to note that rules for borrowing against your 401K will vary from custodian too custodian. Plus, you’ll need to do a little extra work to make this possible (see 3rd part admin below). But being able to easily borrow money from your 401K for ANY use you want, is extremely handy. Another HUGE plus for this type of account in my opinion.

3) What Are the Investment Options?

SEP IRA – Investment options are generally the same as those of a regular IRA or brokerage account, and include stocks, bonds, mutual funds, ETFs, etc. Anything you can buy through your standard account at your brokerage, you can buy with this account.

Solo 401k – These are available at most significant brokerages, so investment options are the same as what is available in any standard brokerage or traditional IRA account. However, there may be some restrictions in place depending on the custodian, so it’s best to research before committing to a plan. I use Fidelity, and it’s just like a brokerage account. But AGAIN, you can also borrow from the funds and invest in absolutely anything. Real estate, oil wells, your brother-in-law…anything.

4) Is There a ROTH Version of Either Plans?

A ROTH option allows employees to deposit money into their retirement plans on an after-tax basis. If you are trying to defer taxes now, a ROTH doesn’t help you much. But if for some reason you are unable to make pre-tax contributions, making contributions to a ROTH can be a great thing to do as well. The benefit of the ROTH is that while you pay the tax in the income before the money goes into the account, you pay no tax when it comes out.

SEP IRA – There is no ROTH option available.

Solo 401 – Usually there is a ROTH version available. I know Fidelity has one.

5) Can Funds Be Rolled Over to Another Retirement Plan if Needed?

Yes, in both cases, given certain conditions, the funds can be rolled over to another qualified retirement plan. Usually, this comes in form of a “Rollover IRA”, at least initially.

I have actually rolled all of my other retirement plans and IRAs I had scattered about, into my Solo 401k. It’s so much easier to have all my retirement funds consolidated into one place, finally!

The main reason you would go with the Solo 401k vs the SEP IRA, is the difference in contribution structure. The Solo 401k can accommodate a wider variety of income variation and gives more flexibility in tax planning.

The second best reason to go with the Solo 401k is the ability to borrow off of the funds.

-Joe disanto

Other Pros or Cons for the SEP IRA vs Solo 401k

1) Will I Need 3rd Party Administration, or Have to Do a Bunch of Paperwork?

A third-party administrator is a party (individual or entity) that handles the contributions, distributions and the various paperwork, reporting and filing aspects relating to pension plans. The administrator is hired by the plan sponsor, which is your business.

SEP IRA – Pretty much NO to both. (Which I admit is nice.)

Solo 401k – It depends. If you go with a standard account from a brokerage house, they actually do most of this administration for you, for free even. But the standard account comes with a few limitations, the most significant of which is that you can’t usually borrow off the funds in this simpler setup. At least you can’t with Fidelity.

If you want to borrow off of your Solo 401k, you will need to set up a “non-prototype” account and use third party administration. I use a company called Ascensus, and it costs about 800/year. The only reason I do this is because I really wanted to be able to borrow the funds if I needed to. The good part of this is that they fill out all of your required paperwork.

2) Do I Need to File Any Kind of Tax Return for the SEP IRA vs Solo 401k?

SEP IRA – No employer (you) tax filings have to be made…so that’s good. It is definitely the easier plan in this regard. But, the employee (you) has to report any contribution your employer has made to your retirement plan.

Solo 401k – Yes, if your combined plan assets exceed 250K, you have to file an IRS form 5500 at the end of the year. Your accountant can do this for you. But as mentioned above, if you have third party administration, they will file this for you, as part of their fees.

Conclusion

When is comes to the battle of retirement plans, SEP IRA vs Solo 401k, the Solo 401k is the clear winner (if you are self-employed and you or your spouse are the only employees). Now, if you’re self-employed and have employees and you’re curious as to whether to go with the SEP IRA over the SIMPLE IRA or traditional 401k, I would still say, mostly, no. But that’s a post for another day. Feel free to hit me up with some questions: joe@playlouder.com.

Also, here are some other posts you might be interested in!

The Big Picture of Investing…and the Reasons You Need to Do It Now! (Short Version)

Why You Need to Own Your Residence (of Which You Will Be the World’s Best Tenant!)

4 Comments

    • Thx Jamie. Yes your corp should be “paying you”, as an employee of the corp, some amount of W2 style payroll. You can do this payroll as little as once per year if you want. So the contribution amounts that these plans allow for, are based on that gross W2 pay, that you have issued to yourself. Some accountants will do this for you, but I think you are better off using a payroll service (I use gusto). This way they are doing all your required quarterly payroll filings.

      • Jamie Beckwith

        Thanks for the response Joe! One of the things I’ve found tricky since shifting to freelance is saving for retirement in a tax-advantaged way. My primary sources of income (about 90%) come from 3 larger companies that pay me through their payroll (W2). Smaller companies pay the traditional invoice/1099 way, and I do funnel a percentage of that income into a SEP-IRA. My tax guy said I can’t really save that W2 income from the other companies in a tax advantaged account (over IRA income limits) unless they offer a 401k plan, for instance, to freelancers. The best way I’ve found is to open a brokerage account and invest in index funds for the long term. Am I missing anything?

        • No problem Jaimie. Sorry for the delay in getting back. I agree with your tax guy, If most of your income comes through W2, unless they are offering a 401K to temp employees (which no one does), you can’t really do much with it. Are you in CA? CA has gotten really rigid with companies paying freelancers as W2 now, and this is another lame result of that I suppose. If you want to share with me some specifics over email (ie amounts of income by various employers, how you work for companies..ie at home or onsite, etc.) I may be able to suggest some additonal ideas you could run by your tax guy. joe@playlouder.com.

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