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Which Is Best For Business Owners: Solo 401(k) or SEP?

Feb 04, 2024 By Susan Kelly

Small business owners have a variety of retirement planning alternatives to select from. Traditional or Roth IRAs can be a terrific place to start when saving for retirement. Still, prosperous business owners sometimes want a plan that enables them to defer considerably bigger sums annually.

The Operation of Self-Employed Retirement Plans

Even though SEP IRAs have been available for a while, they continue to be the most straightforward retirement savings option for business owners. Owners may contribute to these profit-sharing schemes for themselves and other eligible employees. The maximum contribution is 25% of business revenue or 20% for sole proprietorships and single-member limited liability corporations.

What Are The SEP IRA and The Solo 401(k)?

According to a 2019 survey from SCORE, a non-profit advisor to small businesses, only 28% of companies with fewer than ten employees have a retirement plan. Plans like the solo 401(k) and SEP IRA can assist close this gap and aid small enterprises in providing for their employees.

Solo 401 (k)

Consider a solo 401(k) as a 401(k) that is exclusively for you or you and your spouse if you are the only two people working for your company. It can offer the advantages of a typical 401(k) plan, such as tax breaks, tax-deferred growth, and tax-free growth if you choose a solo Roth 401(k), as well as some extra benefits that let you hide even more money in your plan.

You can make employee deferral contributions to your self-employed 401(k) up to $20,500 (in 2022), just like you would in a traditional 401(k) (k). And you'll have the option of expanding the plan.

RESP SEP

The SEP-IRA expands on the classic IRA concept to meet the needs of independent contractors, business owners, and other people who have employees. SEP, which stands for "simplified employee pension," enables employers to contribute to their employees' retirement plans, allowing them to use their workplace as a vehicle for retirement savings.

Important Distinctions Between The Solo 401(k) and SEP IRA

You can save roughly the same year in a solo 401(k) and a SEP IRA, but both plans differ significantly. It would help if you studied the fine print to determine which plan is appropriate for your circumstances.

Rates Of Contribution

The solo 401(k) might speed up your savings despite having comparable annual contribution caps. The SEP-IRA saves up to 25% of your income. In contrast, a solo 401(k) allows you to contribute up to 100% as an employee up to the yearly limit before switching to employer contributions at a rate of up to 25%.

Viability Of Hiring Extra Personnel

The solo 401(k) does not apply to a business with employees, except a spouse employed by the business. In that situation, you might choose the SEP IRA, which enables you to set up a plan for numerous employees. When creating a plan for your employees, you should weigh the pros and cons of the SEP IRA and SIMPLE IRA to determine which is more advantageous.

Roth Alternative

The solo 401(k) is your only choice (apart from a Roth IRA) if you're seeking the alluring tax-free growth of a Roth plan (k). In addition to pre-tax payments, the solo 401(k) lets you make after-tax contributions. The SEP IRA, in contrast, limits you to the regulations of a regular IRA even though the annual maximum contribution is significantly more than that particular plan.

How To Use A Self-Employed Retirement Plan

It would help if you generated revenue from your own business, whether a full-fledged firm or freelancer, to take advantage of a self-employment retirement plan and its different perks.

However, self-employment retirement plans provide many of the same advantages as traditional retirement plans in many other ways. For instance, the solo 401(k) functions quite similarly to the employer-sponsored 401(k) that millions of Americans already have.

The yearly employee contribution maximum for the solo 401(k), which contains both standard and Roth options, is equal to that of a business 401(k) (k). Additionally, it provides catch-up contributions.

Summary

The solo 401(k) and SEP IRA have comparable yearly contribution limits, but the 401(k) may be a superior choice for single freelancers.

The solo 401(k) only works for firms with one owner, but it allows you to save money in the account considerably more quickly (or with a spouse). Additionally, unlike the SEP IRA, the solo 401(k) offers a tempting Roth alternative.

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