If you’re self-employed and looking to save for retirement, two standout options are the Solo 401(k) and the SEP IRA. Both offer significant tax advantages and high contribution limits compared to traditional IRAs, but they cater to different needs and circumstances. Let’s break down how they compare and their pros and cons to help you make the best choice.
What is a Solo 401(k)?
A Solo 401(k), also called an Individual 401(k), is designed for business owners with no employees (aside from a spouse, if applicable). It functions similarly to a traditional employer-sponsored 401(k) but allows you to contribute as both an employee and an employer.
What is a SEP IRA?
A Simplified Employee Pension Individual Retirement Account (SEP IRA) is a retirement plan primarily aimed at small business owners and self-employed individuals. Contributions are made solely by the employer (which, in this case, is you), and all employees must receive the same percentage of pay contributed to their accounts.
Key Differences
| Feature | Solo 401(k) | SEP IRA |
|---|---|---|
| Eligibility | No employees (except spouse). | Any business with or without employees. |
| Contribution Structure | Employee and employer roles. | Employer-only contributions. |
| Contribution Limits | Up to $70,000 (2025), split between $22,500 employee deferral + 25% of net earnings (up to $330,000 cap). | 25% of net earnings, capped at $70,000 (2025). |
| Catch-Up Contributions | $7,500 (for those 50+). | None. |
| Setup and Maintenance | More complex, may require IRS filings once balance exceeds $250,000. | Simpler to set up and maintain. |
| Roth Option | Available. | Not available. |
| Loans | Allowed. | Not allowed. |
Pros and Cons of Solo 401(k)
Pros
- Higher Contribution Potential: The ability to contribute as both an employee and employer allows for larger contributions, especially for high-income earners.
- Catch-Up Contributions: If you’re 50 or older, you can contribute an additional $7,500 annually.
- Roth Option: A Roth Solo 401(k) lets you contribute after-tax dollars and enjoy tax-free withdrawals in retirement.
- Loan Access: You can borrow up to 50% of your account balance, up to $50,000.
Cons
- More Administrative Work: Requires more paperwork and may involve annual IRS filings if the account balance exceeds $250,000.
- Eligibility Limitations: Not suitable if you plan to hire employees other than your spouse.
- Complex Setup: Generally more complicated to establish than a SEP IRA.
Pros and Cons of SEP IRA
Pros
- Simple to Set Up: Many financial institutions offer SEP IRAs, and they involve minimal administrative effort.
- High Contribution Limits: Allows up to 25% of net income, providing ample room for savings.
- Ideal for Businesses with Employees: Contributions are straightforward and proportional for all employees.
Cons
- No Roth Option: Contributions are always pre-tax, so withdrawals are taxed in retirement.
- Lower Contributions for Lower Income: Unlike a Solo 401(k), there’s no employee deferral, so lower income equals smaller contributions.
- No Catch-Up Contributions: Older workers cannot contribute extra beyond the standard limit.
Which Should You Choose?
Solo 401(k): Best for High Earners Without Employees
If you’re a high-income self-employed individual or business owner and want to maximize retirement savings, the Solo 401(k) offers unmatched flexibility and higher contribution limits. The Roth option is an excellent perk if you expect to be in a higher tax bracket later in life.
SEP IRA: Best for Simplicity or Small Businesses with Employees
If you prefer a straightforward setup or have employees (and can afford to contribute on their behalf), the SEP IRA is a practical choice. It’s also a great stepping stone for those new to self-employment and looking for an easy way to start saving.
Final Thoughts
Both the Solo 401(k) and SEP IRA can serve as excellent tools to grow your retirement nest egg. In general, if you are a self-employed, you can utilize Solo 401(k) for possible higher contributions and Roth 401(k). However, beware that you are required to file Form 5500-EZ or Form 5500-SF if your income exceeds 250,000.