One of the best tax deductions for a small business owner is funding a retirement plan. Beyond any tax deduction you are saving for your own retirement. As a fellow small businessperson, I know how hard you work. You deserve a comfortable retirement. If you don’t plan for your own retirement who will? Two popular small business retirement plans are the SEP-IRA and Solo 401(k).
SEP-IRA vs. Solo 401(k)
| SEP-IRA | Solo 401(k) | |
| Who can contribute? | Employer contributions only. | Employer contributions and employee deferrals. |
| Employer contribution limits | The maximum for 2022 is $61,000, this has been increased to $66,000 for 2023. Contributions are deductible as a business expense and are not required every year. A SEP-IRA can be opened and funded up to your business tax filing date, including extensions. | For 2023, the employer and employee combined contribution limit is a maximum of $66,000 and $73,500 for those who are 50 or over, respectively. Employer profit sharing contributions are limited to a maximum of 25% of the employee’s compensation. They are deductible as a business expense and are not required every year. |
| Employee contribution limits | A SEP-IRA only allows employer contributions. Employees can contribute to an IRA (Traditional or Roth, based upon their individual circumstances). | Employee contribution limits are $22,500 for 2023. An additional $7,500 catch-up contribution is available for participants 50 and over. In no case can total employee contributions exceed 100% of their compensation. |
| Eligibility | Typically, employees must be allowed to participate if they are over age 21, earn at least $600 annually, and have worked for the same employer in at least three of the past five years. | No age or income restrictions. Business owners, partners and spouses working in the business are generally eligible to contribute. Common-law employees are not eligible. |
Note the Solo 401(k) is also referred to as an Individual 401(k).
- While a SEP-IRA can be used with employees in reality this can become an expensive proposition as you will need to contribute the same percentage for your employees as you defer for yourself. I generally consider this a plan for the self-employed.
- Both plans allow for contributions up your tax filing date, including extensions for the prior tax year. Consult with your tax professional to determine when your employee contributions must be made. The Solo 401(k) plan must be established by the end of the calendar year.
- The SEP-IRA contribution is calculated as a percentage of compensation. If your compensation is variable the amount that you can contribute year-to year will vary as well. Even if you have the cash to do so, your contribution will be limited by your income for a given year.
- By contrast you can defer the lesser of $$22,500 and $30,000 (for those who are 50 or over) for 2023 into a Solo 401(k) plus the profit sharing contribution. This might be the better alternative for those with plenty of cash and a variable income.
- Loans are possible from Solo 401(k)s, but not with SEP-IRAs.
- A Roth feature is available for a Solo 401(k) if allowed by your plan document. Beginning in 2023 the ability to open and fund a Roth SEP-IRA is available as part of the recently passed Secure 2.0 rules. There will likely be some additional guidance on Roth SEPs from the IRS to come.
- Both plans require minimal administrative work, though once the balance in your Solo 401(k) account tops $250,000, the level of annual government paperwork increases a bit.
- Both plans can be opened at custodians such as Charles Schwab, Fidelity, Vanguard, T. Rowe Price, and others. For the Solo 401(k) you will generally use a prototype plan. If you want to contribute to a Roth account, for example, ensure that this is possible through the custodian you choose.
- Investment options for both plans generally run the full gamut of typical investment options available at your custodian such as mutual funds, individual stocks, ETFs, bonds, closed-end funds, etc. There are some statutory restrictions so check with your custodian.
- For those wishing to invest in alternative assets inside of their SEP or solo 401(k), a number of self-directed retirement plan custodians offer this option.
Both plans can offer a great way for you to save for retirement and to realize some tax savings in the process. Whether you go this route or with some other option I urge to start saving for your retirement today.
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Good comparison of the two Roger! This is something we’re going to have to be dealing with ourselves now that we run our own business. We actually have some cash on the side waiting to fund an IRA depending on what our taxes will look like. One thing I was not aware of was the eligibility requirements behind the SEP. So, if I am reading it correctly, if you’re business is less than three years old then you would not qualify to have a SEP…is that correct? Or, since it is our business would we (generally) be good to go?
Thanks for the comment John. As far as SEP eligibility what I listed was the longest that you can typically require until an employee is eligible. In the case of you and your wife you would be good to go, but consult with the custodian you decide upon (Vanguard, Fidelity, Schwab, etc.) about any rules along these lines. They generally have folks who are knowledgeable on these plans. The bigger point is that for a firm with employees a SEP can get quite expensive quickly, I generally have only used it for self-employed clients, including spouses working together.
Thanks Roger, that makes sense. We may add employees at some point down the road so that will be something we have to look at then.
I never really paid attention to SEP IRAs as they never applied to me, however as I look more and more into becoming self employed I see that I need to get spun up on them fast. Thank you for sharing.
Marvin thanks for the comment. Depending upon your situation both the SEP-IRA and Solo 401(k) might be worth a look. Feel free to contact me directly with any questions.
In light of the performance of traditional investments, a Solo-401(k) may be preferable. You mentioned investments are governed by the custodian, however, the trustee may be able to invest in non-qualified assets.
Lisa thanks for your comment. By non-qualified assets I’m assuming you mean things such as a business or real estate? If that is case my comment is that just because someone is able to doesn’t mean they should.
Max 2012 limits are $50,000, not $51,000.
Thanks for the note, can’t believe I didn’t catch that fixed the article.
Roger, you really need to add traditional defined benefit plans to your mix. A 55 year old business owner can contribute 100% of his pay, or more into a traditional plan – a much more lucrative alternative to any type of IRA or 401 (k) plan.
Jim thanks for the note. While I agree that DB plans (including cash balance) can be an excellent option, the intent of this article was ONLY to compare and contrast the SEP and Solo 401(k). An article with a broader scope dealing with the range of alternatives would need to include DBs as you point out.
Good summary of the two! Being an employee, I’ve had very little experience with either of these. So its good to see comparisons like this and understand the differences between the them. Its good to know that if I was self-employed I would have these to use at my disposal.
Thanks for your comment. Depending upon one’s situation, both plans offer some good options and have some pros and cons. At the end of the day, I always encourage anyone who is self-employed to start saving for their retirement in either plan or one of the other options available as soon as possible. Business owners work hard and deserve the best retirement possible.
Very comprehensive guide for these two plans. These are great options for any small business, but as you say they make the most sense where there are no other employees or there are only a few who make low wages. Also remember that part time employees who work less than a 1000 hours may be excluded. Anyone considering such plans should get with their tax attorney or tax accountant to explore which one is best for their particular situation.
Steven thanks for your comment and I totally agree with you.
What do you recommend for a real estate agent to open?
Thanks
Philip thanks for your comment. Without knowing the particulars of your situation its hard to provide a definitive answer. The SEP-IRA provides the most flexibility in terms of being able to open one right up until you file your taxes for the prior year and in terms of minimal paperwork. While the contribution limits are high, if you have a down year income wise but still have the cash to contribute you will be limited in terms of the level of your income. For this reason the Solo 401(k) might be a good choice. Both are generally easy to open at places like Fidelity, Schwab, TD, Vanguard, etc. If you want to contact me directly (via the contact page of the blog) I’d be glad to discuss your situation in a bit more detail.
Great article! I have been self-employed for 17 years and always contribute the max to a SEP, but as I now see retirement (hopefully) 10 years away and can sock away more of my income, I’m wondering if a 401K-solo is a better option. I was initially considering keeping the SEP and also opening/contributing to a Roth IRA, which I was told I could do (I am over 50). Your thoughts?
Tina thank you for your comment. A lot depends upon your situation, the consistency of your income stream and other factors. I’d be glad to speak with you offline please feel free to contact me
If you have a solo 401k, can you transfer from it to a SEP IRA any time you want?
Can you contribute to both a solo 401k and a SEP IRA in the same year?
If you have a solo 401k, are you required to contribute to it at all, or can you choose a SEP IRA in any given year?
Mark thanks for your comment. In answer to your first question, the answer is generally yes. To the second question again I believe the answer is yes, but remember the contribution limits for each type of plan. There is a maximum contribution that you will be allowed and this is a combined limit. You are never required to contribute to either your SEP-IRA or your Solo 401(k). My question to you is why would you want both? Frankly in many cases the Solo 401(k) will provide the most contribution flexibility, but each situation is different.
A SEP IRA is what I know and understand, and I like the flexibility. I can easily move it from firm to firm, I can have multiple IRA’s at different firms, I can easily do a Roth conversion, etc. I do like the higher contribution limits of the 401k. I spoke to one firm offering the 401k, and they told me about all the limitations, so now I am trying to determine if these are limitations just there, or if these are IRS limitations. They told me I cannot move funds from the 401k to a SEP without a “qualifying event”, like death, disability, closing the 401k, etc. And according to them, I need a legitimate business reason to close the 401k, and if I close it after the first year, the IRS will ask why. They also said I cannot have multiple 401k’s at different firms, and that if I have a 401k, I am expected to contribute to it, rather than a SEP. They said I cannot split my allowable contribution between the two, and each year I must choose the SEP or the 401k. I’d prefer to use the 401k just to contribute the amount not allowed in a SEP and continue building up my SEP, and if possible transfer it out from the 401k to the SEP as quickly as possible.
My reaction to your comment is that you are making this way too complicated. IRA’s at multiple firms, moving from firm to firm? I don’t get it, seems like the focus is on everything except planning your investments and your retirement needs. Just my observations in reaction to your comments.
So I have decided to open a solo 401k plan to invest the extra income. I went online to IRS website and got an EIN specifically for the solo 401K but then when I later spoke with another IRS agent, he stated that I needed another EIN # as a sole proprietor and went ahead to issue me another. So I now have 2 EIN #.
So please which do I use for my solo 401K application? And does having two EIN # complicate my tax filing issue? Thanks
Chaz thanks for your note and kudos on the decision to open a Solo 401(k). Glad to try to answer your questions, however please contact me directly via the contact page of this blog hard to address in this forum. Thank you.
Great article. I am newly self employed and have an S corp. I have 2 401Ks from previous emplyers. One from when I was a kid in college that I never moved or did anything with. The second from my most recent employer. I am trying to decide on the benefits of doing a solo 401K versus a SEP. I guess I can rollover the previoous 2 plans into a the new plans whichever one i decide on. If i decided I didn’t want the 401K can I change over to a SEP? I am single, no dependents. I want to maximize any tax benefits etc.
Thanks Leslie, glad you found it helpful. Please feel free to contact me via the contact form on the blog if you have some specific questions that you would like to discuss.
Roger, in response to Mark about having both a SEP and a solo 401K you wonder why he would want both. It seems to me that because you can contribute the maximum percentage of your compensation to one plan without hitting the dollar max, you’d want to contribute to the other plan to the point you reach that dollar max, and your maximum deduction.
Jim thanks for your comment. My comment to Mark was more about his making this way more complicated that I think this needs to be. I’ve never actually seen anything that says you can’t contribute to both and in certain situations it might make sense to use both to contribute the max dollar amount. My only caution would be to say that one should be sure to work with a financial or tax advisor who understands the overall dollar and percentage limits on these plans.
Amen to that, Roger. Wise advice for anyone confronted by a complex issue. Thanks for the reply.
If I have an S-corp consulting company and I’m the only employee but have a unusually great year and want to minimize my taxable income, can I hire my spouse and pay her $208K in W2 wages in addition to my own $208K W2 wages and double up on the maximimum SEP contribution of $52K per person for a total tax deductible contribution of $104K? Or is it $52K max SEP contribution per couple/household? I’m considering my options that also include a combo of 401K, profit sharing, and defined benefits plan which commits me to future contributions even if my future years aren’t quite so great from a cash flow standpoint (which is my main concern)
Dave thanks for your comment. First let me say that I do not hold myself out as any sort of tax expert. That said the SEP contribution limits are per person not per couple. Likewise with a solo 401(k) if that is under consideration. I would guess at some point, if asked, you would need to document that your wife is actually an employee of the business. I’d be glad to discuss your situation in more detail offline if you’d like, please feel free to contact me via the contact form on this blog.
OK, thanks Roger for the advice.
Thanks for the article. For the Solo 401 (k), is the deadline for funding your contribution your tax filing deadline for both the employee and the employer portions? For 2014 (for example), for the employee contribution, assuming the solo 401(k) account is open and your deferral amount is reported correctly on your w-2, can you wait until April 15, 2015 to actually fund your contribution?
Christy thank you for your comment. You are correct, as long as the account is opened by 12/31 of 2014 in this case you generally have until your filing date to fund both portions including extensions. To be doubly sure however I would check with your custodian and perhaps your accountant.
Thanks for this interesting article. Will you post more articles on the same topic anytime soon ?
Alan thanks for the comment. I think a 2015 update is a good idea and will put it on the editorial calendar. Beyond that are thee any particular questions that you have about small business retirement plans? Glad to try and address them in a post or offline.
Hey Roger,
I am in a situation where I own 2 separate businesses. One business has no employees and the other business has full time and part time employees. I take it from your article, that a 401k is better for owner retirement planning when the business has employees because an SEP requires equal % contributions to employees as the owner. Is that correct? If so and given that there are 2 separate companies, am I able to max out each retirement plan at both companies?
Barry thanks for your comment. Much of your question is more detailed than I can answer via this forum, please feel free to email me via the contact tab. To the last question, the contribution limits are for all plans in total. For example the 401(k) $18,000 max salary deferral is for all plans, you can’t do $18,000 in each of two plans. Also note the Solo 401(k) is just for an owner with perhaps a spouse and a business partner. Beyond that you would need to do a regular 401(k).
a taxpayer is self employed and has a sep account established prior to current year, taxpayer dies in October and has earned enough to contribute the max to a sep plan.Can his spouse make the contribution to the deceased spouses sep account.
Thanks for your comment. I’v e never been asked this question nor have I ever encountered it. My first inclination would be to say that contributions cannot be made for an individual after their death, but that is just a guess. I would consult an attorney versed in this area if this is a real situation.