The individual or solo 401(k) and the Simplified Employee Pension IRA (“SEP-IRA”) are probably the two most prevalent types of retirement savings accounts for the self-employed. They both offer a number of advantages, but there are a number of rules surrounding these accounts as well.
Understanding Individual 401(k) and SEP-IRA
An individual 401(k), also known as a solo 401(k) or a one-participant 401(k), is a retirement savings plan designed for self-employed individuals and small business owners with no employees other than their spouse. Partners in the business may also participate.
The solo 401(k) offers the opportunity to contribute as both an employer and an employee,
allowing for higher contribution limits compared to IRAs. Employee contributions can be made up to the same annual limits as an employer 401(k) plan.
A SEP-IRA is a retirement plan suitable for self-employed individuals and small business owners with a few or no employees. The SEP-IRA enables employers to make contributions on behalf of both themselves and their eligible employees. These plans are known for their simplicity in administration and flexible contribution amounts. No employee contributions are allowed.
Comparing the Solo 401(k) and SEP-IRA
Both types of plans offer some benefits and some drawbacks.
1. Higher Contribution Limits: Individual 401(k)s often allow for higher contribution limits compared to a SEP-IRAs, enabling you to save more for retirement.
2. Dual Contributions: As both an employer and an employee, you can contribute to the plan, maximizing your savings potential. This can be especially important if your income slips in a particular year.
3. Catch-up Contributions: If you are 50 or older, you can make additional catch-up contributions, further boosting your retirement fund. For 2023, this is equal to $7,500 if you are 50 or over.
4. Loan Options: Some individual 401(k) plans offer loan provisions, allowing you to borrow against your account balance if needed. This will depend upon the custodian offering the plan.
5. Roth Option: Depending on the plan, you might have the option to make Roth contributions, providing tax-free withdrawals in retirement.
1. Complexity: Compared to SEP IRAs, individual 401(k)s can be more complex to set up and administer, especially if you are the only participant.
2. Administrative Burden: With higher contribution limits come additional administrative responsibilities, a solo 401(k) can potentially require more paperwork, especially when the account balance exceeds $250,000.
3. Potentially Costlier: The administrative and setup costs associated with an individual 401(k) may be higher than those of a SEP-IRA.
1. Simplicity: SEP-IRAs are relatively easy to establish and maintain, making them an attractive option for small business owners and self-employed individuals.
2. Flexible Contributions: Employers have flexibility in deciding how much to contribute each year, offering adaptability based on business performance. Contributions are made as a percentage of employee compensation.
3. No Discrimination Testing: Unlike a small business 401(k), SEP-IRAs do not require complex nondiscrimination testing, simplifying plan management.
4. Tax Deductible Contributions: Employer contributions to SEP-IRAs are tax-deductible, reducing your business taxable income.
5. Roth Option: With the passage of Secure 2.0, SEP-IRAs can now offer a Roth option.
1. Limited to Employer Contributions: Unlike individual 401(k)s, only the employer can contribute to SEP-IRAs, and contributions are solely based on a percentage of employee compensation. If that compensation is particularly low in a given year, this can limit the business owner’s ability to contribute.
2. Employer Contribution Percentages: For a plan with employees, the employer must contribute the same percentage of compensation for each eligible employee as they do for themselves. This can make the SEP-IRA an expensive proposition in some cases.
3. No Catch-up Contributions: Unlike individual 401(k)s, SEP IRAs do not offer catch-up contribution options for those aged 50 or older.
Key Deadlines for Establishing and Funding
An individual 401(k) must be established by December 31 of the current year in order for funding to be allowed for the current tax year. Typically, employee contributions can be made up to December 31 for the current year. Employer contributions can be made up to the tax filing deadline for the business, including extensions.
For a sole proprietor, these dates will be the same as for the owner’s individual returns. If they file a separate business tax return, the dates will coincide with the business tax filing dates. It is always best to consult with your tax professional on this.
A SEP-IRA can be established and funded up to the tax filing date for the business, including extensions. As with a solo 401(k), this will either be the filing dates of the owner’s individual return or business return depending on their situation.
The annual contribution limits for employee contributions are the same as for an employer sponsored 401(k). For 2023, these limits are $22,500 plus an additional $7,500 in catch-up contributions for those who are 50 or over.
Employer profit sharing contributions are based on 25% of employee compensation up to a limit of $66,000 or $73,500 for those who are 50 or over.
All contributions to a SEP-IRA are made by the employer. They are based on 25% of employee compensation. The limit for 2023 is $66,000.
Which plan is right for you?
This will depend upon your situation, including your income and cash flow. Your Wedbush financial advisor can help you choose between a solo 401(k), a SEP-IRA or other options to save for your retirement.
Wedbush Securities does not provide tax or legal advice. Please consult your tax or legal advisor.
These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information presented is not intended to constitute an investment recommendation for, or advice to, any specific person. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. The information in these materials may change at any time and without notice.