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Retirement

Solo 401k vs SEP IRA

Overview

  • Any business owner or self-employed individual, with or without employees, can contribute to a SEP IRA.
  • To contribute to a solo 401k, you must not have any employees that work more than 1000 hours per year in your business (besides your spouse).
  • Both have a contribution limit of $61,000 in 2022. The solo 401k offers catch-up contributions of an additional $6,500 if you're 50 years of age or older.
  • A SEP IRA can only accept contributions from employer compensation. Employees are not allowed to contribute. You can contribute up to 25% of your compensation (20% if you're a solo practitioner or single-member LLC).
  • A solo 401k allows both employer and employee compensations. You can contribute up to 100% of your income up to $20,500 ($27,000 if you're over 50) as an employee. You can contribute up to 25% of your compensation (20% if you're a solo practitioner or single-member LLC) as an employer.
  • A SEP IRA requires contribution matching for any employees in your business. If you contribute to your SEP IRA, you also have to contribute the same percentage for every employers' SEP IRA as well.
  • A solo 401k has a Roth option, allowing you to contribute up to $20,500 in 2022 ($27,000 if you're over 50). The SEP IRA has no Roth option.
  • A solo 401k gives you the option to take a loan up to 50% of your plan value, max $50,000. The SEP IRA has no loan option.

The solo 401k and SEP IRA are retirement accounts created for small business owners and self-employed individuals.

Both have the same contribution limit, tax-free compounding, and allow all business entities to be eligible.

However, a solo 401k has many more advantages than a SEP IRA. But not everyone qualifies for one. Depending on your business, one might make more sense over the other.

Let's take a look at the key differences.

The Ocho Solo 401k Plan makes setting up a solo 401k simple, with managed tax filings, curated investments, and zero fees on your assets under management. Learn more here.

Eligibility Rules

For both the SEP IRA and the solo 401k, you must be a business owner or be self-employed.

The only difference eligibility between the two is that one is allowed to have employees, and the other is not.

  • With a solo 401k, you must not have any employees that work in your business more than 1000 hours per year (other than your spouse).
  • With a SEP IRA, you’re allowed to have employees.

You can also open a SEP IRA if you’re self-employed with no employees.

But if that’s the case, that means you meet the requirements for a solo 401k, which is the superior plan for several reason that we’ll go through below.

Contribution Limits

The contribution limits for both the SEP IRA and the solo 401k is $61,000 for 2022.

If you’re over 50 years old, the solo 401k also gives you an additional $6,500 in catch-up contributions. This brings your total contribution limit to $67,500. 

There is no catch-up contribution for the SEP IRA.

The real difference in contributions, however, is not in the limit, but how you're allowed to contribute.

How You Can Contribute

The contribution limits might be the same, but one of the biggest differences between the two accounts is HOW you can contribute to your plan.

  • With a solo 401k, you get to contribute to your account as BOTH the employer and the employee.
  • With a SEP IRA, you can ONLY contribute to your account as the employer. Employees are not allowed to directly fund a SEP IRA with their compensation.

This creates a significant difference in how much money you need to maximize contributions to both plans.

Maximizing Contributions

With a solo 401k, because you’re allowed to fund your account as both employer and employee, you need less money to maximize your plan than with a SEP IRA.

Remember that the contribution limits are the same for both, $61,000 for 2022.

Employers are allowed to contribute up to 25% of their compensation. This is the same for both the SEP IRA and solo 401k.

However, wth a solo 401k, you can also contribute up to 100% of your income up to $20,500 on the employee side.

Let’s go through the calculations.

SEP IRAs are only allowed to be contributed with employer compensation. You’re allowed to use up to 25% of your compensation.

  • That means, to maximize contributions of $61,000, you would need to make $244,000 (25% of $244,000 is equal to $61,000).
  • With a solo 401k, you have the same contribution limit of $61,000. However, you can contribute up to $20,500 as an employee.

If you maximize your employee contributions, you’re left with $40,500 in contribution room remaining to contribute to on the employer side.

To maximize contributions on the employer side, you would need to make $162,000 (25% of $162,000 equals $40,500).

So, basically, you need $244,000 to maximize contributions for SEP IRA and just $162,000 to maximize contributions for a solo 401k.

That’s a difference of $82,000.

*These numbers are only a simple example and don't reflect all tax and deductions for the year.

But that’s not all. It actually gets even more expensive for SEP IRAs if you have employees.

Matching employee contributions for SEP IRAs

Remember that a SEP IRA can only be funded by employer compensation. Employees cannot directly fund a SEP IRA.

One of the rules that come along with a SEP IRA is matching contributions for employees.

If you contribute to your SEP IRA, and you have employees in your business, you must contribute the same percentage to your employees’ SEP IRAs as well.

For example, if you decide to contribute 25% of your compensation into your SEP IRA, you must also contribute 25% of each employees’ individual compensations into their SEP IRAs.

As you can see, if you have a lot of employees, it can get really expensive and it might not make sense to have a SEP IRA.

Note: You only have to match contributions for employees who are at least 21 years old, worked for you for three out of the last five years, and earned at least $650 from you in the past year.

Roth option

The SEP IRA and the solo 401k both have some of the highest contribution limits out of all retirement accounts.

However, one of the biggest distinctions between a SEP IRA and a solo 401k is that the solo 401k has a Roth option, while the SEP IRA does not.

Out of all the differences between the two accounts, the absence of a Roth option in the SEP IRA is what makes it inferior to the solo 401k.

How the Roth option works

The Roth option only applies to the employee side of contributions. You can elect to contribute up to the maximum limit of $20,500 into a Roth solo 401k over a traditional solo 401k.

You can read the full breakdown of the two plans here, but here's a summary of what that means.

Remember that with a solo 401k, you contribute as both the employer and the employee. On the employee side, you can choose whether you want to contribute that money into a Roth account or a normal account.

The Roth solo 401k account works similarly to a Roth IRA: You contribute money with after-tax dollars, but you don't pay any taxes when you withdraw in retirement.

Considering that your money compounds tax-free, the tax savings of a Roth account at the time of withdrawal can be huge.

But the reason why the solo 401k is considered the best retirement plan is because the Roth portion of the plan is three times bigger than a Roth IRA.

The contribution limit of a Roth IRA account is just $6,000 ($7,000 if you're over 50). The contribution limit of the Roth solo 401k plan is $20,500 ($27,000 if you're over 50).

The Roth portion of a solo 401k only applies to the employee side. The employer side can only be contributed to a pre-tax account.

The SEP IRA has no Roth option. You pay with pre-tax dollars, get a tax deduction, but you pay taxes when you withdraw from your account in retirement.

Withdrawal rules

The withdrawal rules for both the SEP IRA and the solo 401k work the same.

You must wait until you're at least 59½ years of age in order to withdraw from either account. Any early withdrawals are subject to a 10% fee plus income tax on the amount drawn.

The withdrawal tax works a little differently, due to the Roth option of the solo 401k.

The traditional solo 401k and the SEP IRA are both funded with pre-tax dollars. When you withdraw, you'll have to pay taxes on the withdrawn amount according to the tax rate at the time and what tax bracket you fall under.

However, when you withdraw from the Roth portion of the solo 401k, you don't pay any taxes on the withdrawals.

Loans

With a solo 401k, you're given the option to take a loan from your account, while no such option exists with a SEP IRA.

You're allowed to borrow up to 50% of your plan value up to $50,000. Interest rates vary depending on your plan provider, but it's usually based on the current Prime Rate plus another one or two percent.

While it's nice to have the option, it can't really be called a perk or benefit because of the repercussions of taking a solo 401k loan.

You're basically withdrawing money from your retirement account and paying the interest to the government. While the interest rate isn't terrible, the real damage comes from taking money that would otherwise be compounding for you tax-free in your account.

Which one’s better?

For other retirement account comparisons, the answer to this question is usually: “it depends”.

But in this case, IF you qualify for both accounts, the solo 401k is almost always the better choice.

Here’s why:

  • A solo 401k has a Roth Option while a SEP IRA does not.
  • They both have the same contribution limit of $61,000, but with a solo 401k, you can contribute both as the employer and as the employee with a solo 401k. With a SEP IRA, you can only contribute employer compensation.
  • As a result, you can maximize a solo 401k with less money than you can with a SEP IRA.
  • With a SEP IRA, that $61,000 limit can only be funded with up to 25% of your compensation. With a solo 401k, you can contribute up to 100% of your compensation up to $20,500 as an employee. The remaining amount is funded with up to 25% of your compensation as an employer.

On the bright side, a SEP IRA is much easier to set up than a solo 401k. Not every broker offers a solo 401k plan. And if they do, not every plan offers the full benefits (like a Roth option).

A solo 401k also requires a lot of paperwork during set up, and more management to stay in compliance each year.

The Ocho Solo 401k Plan comes with a Roth option, easy account setup, managed tax filings, and zero fees on your assets under management. Learn more.

If you don't qualify for a solo 401k, a SEP IRA is a good option for business owners with few employees and a high income.

It's also a quick and easy way to set up retirement plans for your employees. Having automatic contributions to their SEP IRA can also be attractive for potential employees of your business.

Just remember that the SEP IRA has employment contribution matching rules. Whatever percentage you contribute to your SEP IRA, you also have to contribute to every single employee's SEP IRA as well.

Can you have both a SEP IRA and a solo 401k?

Yes. Let's say you have two businesses. One has employees and the other doesn't. You would be able to contribute to a SEP IRA for the business with employees, and contribute to a solo 401k for the business with no employees.

What are the advantages of having both?

The main reason would be to take advantage of employee contributions to the Roth option, since a SEP IRA does not provide one.

SEP IRA Solo 401k
Eligibility Any business owner or self-employed individual with or without employees Any business owner or self-employed individual with no employees (other than your spouse)
Contribution Limit $61,000 $61,000
Employer Contributions Yes, 25% of compensation (20% for solo practitioners and single-member LLCs) Yes, 25% of compensation (20% for solo practitioners and single-member LLCs)
Employee Contributions No Yes, up to 100% of compensation up to $20,500 ($27,000 if you're over 50)
Roth Option No Yes
Loan Option No Yes, up to 50% of plan value up to $50,000
Withdrawal Age 59½ years old 59½ years old

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