SEP IRA vs. Solo 401(k): Which Is Better?

Quick Answer

Both SEP IRAs and solo 401(k) accounts are retirement savings vehicles you can use if you’re self-employed. The SEP IRA is generally simpler and less expensive to set up, but the solo 401(k) may offer more flexibility and allow bigger contributions.

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Business owners or solo entrepreneurs may be able to choose their own retirement savings vehicle―and enjoy tax savings in the bargain―with a Simplified Employee Pension (SEP) IRA or a solo 401(k). Both can help you save for retirement, and the better choice may depend on how your business is structured and the investment choices you seek.

What Is a SEP IRA?

A SEP IRA is a retirement plan that can be established by any employer, including a self-employed person. SEP IRAs were authorized by Congress in 1978; they have been around much longer than solo 401(k)s.

Setting up a SEP IRA is simple by design. Once you choose a provider, typically a bank, credit union or investment brokerage, you'll be offered an easy, guided setup.

Your choice of investments may be somewhat limited, in that you'll likely be investing in traditional choices such as stocks or mutual funds rather than cryptocurrency, metals or insurance.

If you're self-employed, your maximum contribution for 2023 will be either 25% of your net compensation or $66,000, whichever is less. As of 2023, SEP IRAs may be offered as Roth IRAs, in which taxes are paid on current income, as well as traditional, tax-deferred IRA contributions.

SEP IRAs do not offer catch-up contributions for people over 50 because they are fully funded by the employer.

If your business expands, and you hire employees other than a spouse, your SEP IRA can be used to cover those employees, so long as your own guidelines for who qualifies are no stricter than those set up by the IRS. However, you will have to contribute the same percentage of compensation to employee accounts as you do to your own.

Pros of SEP IRAs

  • Easy setup
  • Potentially larger contributions than with a traditional or Roth IRA
  • Relatively low administrative and maintenance costs
  • Can be set up as late as the day taxes are due (including extensions) for your business

Cons of SEP IRAs

  • Loans from your saved funds aren't available
  • No catch-up contributions
  • Employee contributions not permitted

What Is a Solo 401(k)?

A solo 401(k) is similar to a 401(k) plan offered by a business, but it is designed for one-person businesses, or one person and a spouse. Solo 401(k)s were created as part of the Economic Growth and Tax Reconciliation Relief Act of 2001. Like their corporate counterparts, solo 401(k)s can be either traditional (tax-deferred) or Roth.

There are two basic requirements for a solo 401(k): self-employment activity and the absence of any employees, other than a spouse.

You can make contributions as both the employer and an employee up to a maximum of $66,000 for 2023. In addition, because you may contribute as an employee, you may be eligible for a catch-up contribution if you are at least 50 years old. Keep in mind that, if you also contribute to a 401(k) plan through a W-2 employer, overall maximums apply to individuals, not accounts.

Pros of Solo 401(k)s

  • Potentially higher contribution limits
  • Flexible contributions
  • Ability to contribute in next calendar year (to shelter income from taxes)
  • Can be set up to allow borrowing from account

Cons of Solo 401(k)s

  • Typically more complicated and expensive setup
  • Higher maintenance costs
  • Cannot be used if you hire additional employees
  • Required reporting to IRS once your account reaches $250,000

Should You Choose a SEP IRA or a Solo 401(k)?

Many financial experts recommend a solo 401(k) because it may allow you to shelter more income from taxes. You can also borrow from a solo 401(k) plan. However, its administrative costs and tax reporting requirements may be greater than those for a SEP IRA. And if your business grows, a solo 401(k) is no longer allowable.

The Bottom Line

Self-employed people are in charge of saving for their own retirement. There are tax-advantaged ways to save, and it's not a one-size-fits-all situation. You may want to consult a financial planner about the very best way for you to save if you're self-employed, but no matter which retirement savings vehicle you choose, getting into the habit of putting money aside is crucial to your continued financial health.