Solo 401(k) vs. SEP-IRA: Which is Better?

by Murray Coleman - Tuesday, 17 September, 2019

Tax-friendly 401(k) retirement savings plans are key benefits offered by companies to help workers build nest eggs for their post-employment lives. 

But what happens if someone chooses to start a smaller firm, or seeks a more entrepreneurial career as a self-employed worker? Even small business owners can find setting up and running a full-blown 401(k) platform for themselves -- and, maybe a few full-time workers -- a resource-intensive proposition. 

Two alternatives allowed by the IRS for those in such circumstances are:

  • SEP-IRAs. This type of a plan is formally referred to by the IRS as a "Simplified Employee Pension Individual Retirement Arrangement." 

  • Individual 401(k) plans. These are commonly known as "Solo" 401(k) plans. 

Let's start with the basics. A SEP-IRA allows an owner to make a 25% annual contribution of profits to eligible employees. For a sole proprietor, it's 20% a year. The maximum contribution you can make for 2019 is $56,000. 

For an employee age 50 or older, the SEP-IRA doesn't allow so-called catch-up contributions. That's a feature in 401(k) plans where such workers can contribute several thousand dollars more a year (up to $6,000 extra in 2019) to increase their overall yearly total. 

The SEP-IRA also limits contributions to pre-tax savings, much like a traditional Individual Retirement Account that employees can typically open separately (and in addition to) any workplace savings plan. 

As a result, participants in SEP-IRA plans can't choose to pay taxes on their earnings in an upfront (pre-tax) manner. This is a popular feature of both personal Roth IRAs and corporate sponsored Roth 401(k) plans. In Roth-styled accounts, savings are generally available to withdraw tax-free in retirement. (It's worth noting that such a trade-off between pre- and after-tax savings options is highly dependent on individual circumstances. For more details, see "Saving on Taxes: Traditional or Roth IRA.") 

Solo 401(k) plans typically offer the same maximum annual dollar contribution level as a SEP-IRA. But it has greater flexibility in terms of letting employees sock away money earlier in any given year. Solo plan participants 50-and-older can also make catch-up contributions, creating additional opportunities to save more each year.

"But only the employee contribution amount can be made in an after-tax fashion -- any employer contribution (i.e., those made based on the owner's net business profits) must be made on a pre-tax basis," says John Dahlin, head of IFA Taxes, a division of Index Fund Advisors. 

Another feature of a Solo 401(k) plan is that it can be set up with a profit-sharing component. With such an option, a business owner can make individual contributions throughout the year. Then, he or she could also contribute another amount based on net business income. "This is where the profit sharing portion of the plan comes into play," says IFA's Dahlin, a CPA who has been working with business owners on such planning strategies for more than a decade. 

As noted above, the maximum personal contribution amount in 2019 for employees and employers was set at $56,000 per person for those using either a SEP-IRA or Solo 401(k). 

"It's possible for a business owner to reach the same maximum contribution rates each year through a SEP-IRA," says Dahlin. "But his or her net income is going to need to be high enough to negate any advantage of the 401(k) plan's profit sharing feature." 

By his estimates for the current tax year, a business owner using a SEP-IRA plan would need to generate net profits of at least $292,000 or so in order to be able to reach the same contribution limits as an owner using an Individual 401(k) plan. 

For individuals over 50, Solo 401k's allow catch-up contributions for employees. In 2019, that can translate into an additional $6,000 per person in deferral contributions. Including savings opportunities in the profit-sharing portion of the plan, this will increase the max for such workers to $62,000. (In a SEP-IRA for 2019, the max contribution amount was $56,000 a person, regardless of age.) 

Business owners should keep in-mind that SEP-IRAs can be initiated up to most tax extension deadlines they might face. On the other hand, Individual 401(k) plans need to be established by Dec. 31 in order to make contributions for that tax year. "With its greater flexibility in terms of timing," says Dahlin, "a SEP-IRA can be set up to retroactively deduct income from the owner's personal returns." 

So which option is better? Dahlin gives this hypothetical example to illustrate basic differences between the two types of retirement savings plans:

  • A sole proprietor who is less than 50 years old with net income of $150,000 could theoretically contribute a maximum of $27,950 in 2019 to a SEP-IRA. With a Solo 401(k), he or she might be able to contribute up to $46,950. "The difference comes down to the additional amount this business person could contribute on the employee side of the equation," says Dahlin.

  • Let's examine the same generic situation where the sole proprietor is aged 50 or older. The SEP-IRA, according to Dahlin, is going to be the same amount in terms of his or her maximum annual contribution. The Solo 401(k), however, would give such a hypothetical person an ability to contribute up to $52,950 in that tax year. 

"The main disadvantage of the Individual 401(k) is that you've got to set it up before the calendar year's end," says Dahlin. 

The bottom line, he adds, is that both a SEP-IRA and Solo 401(k) are viable options available to employees and employers who work in a smaller business or more entrepreneurial environment. "People need to look closely at their own unique financial and tax planning situation," says Dahlin. "One size doesn't fit all when you're trying to choose the best retirement plan for yourself or your workers."

This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There are no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. This article is intended to be informational in nature and should not be construed as tax advice. As a division of Index Fund Advisors, Inc., IFA Taxes provides a wide array of tax planning, accounting, and tax return preparation services for individuals and businesses across the United States. IFA Taxes does not provide auditing or attestation services and therefore is not a licensed CPA firm. IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. Federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter herein.