If you qualify for both a SEP IRA and a Solo 401(k), is there a clear winner? In the past, it was often the case that the tax benefits of a SEP IRA and a Solo 401(k) were similar, particularly if you also had access to a 401(k) plan at a full-time employer. Today the landscape has changed, and in most cases, there’s a clear winner.
This post discusses whether a SEP IRA or a Solo 401(k) is better in situations where the self-employed person qualifies for both plans.
Note that both plans have eligibility requirements. For example, under the tax rules, if you employ anyone other than your spouse for 1,000 hours or more during the year you are ineligible for a Solo 401(k). There are additional tax rules and separate (and additional) plan rules to consider to determine if you are eligible for a particular SEP IRA and/or Solo 401(k).
The Basics
Both the SEP IRA and the Solo 401(k) are self-employed retirement plans. They can be established by legal entities (in this context, often S corporations) or they can be established by individuals that have self-employed income. That self-employment income generally must come through a sole proprietorship or through a limited liability company (“LLC”) that is disregarded for tax purposes and reported on a Schedule C filed with the individual’s tax return.
SEP IRAs
A SEP IRA allows only “employer” contributions. For this purpose, your own sole proprietorship or disregarded LLC can be your employer.
Generally, the employer can make annual contributions of up to 25 percent of eligible W-2 compensation (from a corporation) or 20 percent of an individual’s self-employment income, limited to $66,000 of contributions in 2023.
Today, many financial institutions (including Fidelity, Schwab, and Vanguard) offer low-cost SEP IRA options.
A SEP IRA can be established for a tax year by the deadline for filing that tax year’s tax return, including extensions.
The administrative compliance burden of a SEP IRA is generally very manageable.
History of the SEP IRA vs. the Solo 401(k)
Solo 401(k)s
A Solo 401(k) (sometimes referred to as an “Individual 401(k)”) is a 401(k) plan established by a self-employed individual for their own benefit.
The main advantage of the Solo 401(k) is that it allows annual contributions by the self-employed individual in his/her role as the “employee” and annual contributions by the self-employed individual (or S corporation) in his/her role as “employer.”
Employee contributions are limited to the lesser of earned income or $22,500 ($30,000 if 50 or older) in 2023. Employer contributions are limited to up to 25 percent of eligible W-2 compensation (from a corporation) or 20 percent of an individual’s self-employment income, limited to $66,000 of contributions in 2023. Total employee and employer contributions are limited to $66,000 ($73,500 if age 50 or above) in 2022.
Today, many financial institutions (including Fidelity, Schwab, and Vanguard) offer low-cost Solo 401(k) options.
The administrative compliance burden of a Solo 401(k) is generally very manageable, but note that once there are more than $250,000 in the plan and/or the plan is closed, a Form 5500-EZ must be filed.
The Clear Winner
At this point, you might be saying, “Great, both the SEP IRA and Solo 401(k) are attractive. Is there really a big difference between them? Should I care too much about which plan I establish?”
The answer is that in most cases, the Solo 401(k) is the much better option for a self-employed person. If you are considering a SEP IRA over a Solo 401(k) in a situation where you qualify for both, you ought to think twice about that decision.
Here are the main reasons why the Solo 401(k) is much better than the SEP IRA in most cases.
Employee Contributions
The Solo 401(k) allows employee contributions. If your self-employment income is relatively modest, this greatly increases the amount you could contribute. For example, if Jane, under age 50, has a side-hustle that earns her $10,000 in 2023 after the deduction for one-half of self-employment taxes is accounted for, her maximum Solo 401(k) contribution is $10,000, while her maximum SEP IRA contribution is only $2,000 (20% of $10,000).
Note that this assumes that Jane has contributed $12,500 or less to a workplace 401(k) or similar retirement plan. Using the 2023 limitations, $22,500 is the maximum total employee deferrals Jane can make to her 401(k) and similar plans, so Jane’s other employer retirement accounts should also be considered.
Section 199A and 80% Deductions
I have previously written about the new Section 199A qualified business income (“QBI”) deduction and its impact on self-employed retirement plans. Traditional contributions to both Solo 401(k) plans and SEP IRAs create, for many taxpayers, deductions that are only “80% deductions.” Here is an example.
After self-employment taxes, Joe, a single taxpayer, earns $120,000 from his sole-proprietorship. Joe makes a 10 percent employer contribution ($12,000) to either his Solo 401(k) or SEP IRA. In the 24 percent marginal tax bracket, he expects to save $2,880 ($12,000 times 24%) on his federal income taxes. He is surprised to learn that he only saved $2,304 on his federal income taxes.
How is that possible? While Joe is correct that he receives a $12,000 retirement plan contribution tax deduction, he failed to consider that he lost $2,400 of his QBI deduction. A traditional Solo 401(k) contribution and a SEP IRA contribution is an 80% deduction. In Joe’s case, he received a net federal income tax deduction of only $9,600 (80 percent of $12,000).
Why then would Joe prefer a Solo 401(k) to a SEP IRA? Because the Solo 401(k) gives him a planning option that avoid the 80% deduction issue. Instead of making traditional contributions to a Solo 401(k), Joe can make Roth employee contributions to a Solo 401(k).
Note further that Joe could possibly implement Mega Backdoor Roth IRA planning by making after-tax contributions to his Solo 401(k). Many Solo 401(k) plans do not offer this option, but some do.
The SEP IRA does not offer these options.
Not all financial institutions offer the Roth Solo 401(k) and the after-tax Solo 401(k) contribution options. It is important to understand the features of any particular Solo 401(k) before you adopt it as your plan.
For upper income taxpayers, the 80% deduction phenomenon may not be an issue, considering that the ability to claim the QBI deduction is reduced or eliminated above certain income thresholds. These taxpayers need not prefer the Solo 401(k) to a SEP IRA for QBI deduction reasons, but may prefer to have the increased planning ability, such as the ability to make Roth and/or after tax contributions to the Solo 401(k) that a SEP IRA does not offer. They may also prefer the Solo 401(k) for the reasons discussed below.
Backdoor Roth IRA Planning
The Backdoor Roth IRA is a great planning tool. But the Pro-Rata Rule can cause significant snags. For example, if you execute the two independent steps of a $6,500 Backdoor Roth IRA in a year when you have a separate significant traditional IRA, SEP IRA, or SIMPLE IRA at year-end, you will cause most of the Backdoor Roth IRA to be taxable.
The SEP IRA is a significant roadblock to the ability to execute an efficient Backdoor Roth IRA. A Solo 401(k) does not cause this problem with the Backdoor Roth IRA. For this reason alone many will want to choose a Solo 401(k) instead of a SEP IRA, even if they plan on making traditional deductible contributions to the plan.
Catch Up Contributions
If you are age 50 or older, you can make up to $7,500 (in 2022) in catch up employee contributions to a Solo 401(k).
This option does not exist for a SEP IRA. Thus, for high earning self-employed persons age 50 or older, a Solo 401(k) has an additional advantage over the SEP IRA.
Solo 401(k) Book
This post was originally published in 2019. In 2022 I published Solo 401(k): The Solopreneur’s Retirement Account, a book that goes into much more depth about Solo 401(k)s.
Conclusion
If you qualify for both, generally the Solo 401(k) is better than a SEP IRA. If you are going with a SEP IRA over a Solo 401(k), you should understand the reasons for doing so. Finally, self-employed retirement plans is an area that taxpayers usually benefit from receiving personal advice from a qualified tax advisor.
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This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.