As a self-employed professional, choosing the right retirement plan is essential to building long-term wealth and securing your financial future. Two popular options for self-employed individuals are the SEP IRA and the Solo 401(k). Both offer significant tax advantages, but they differ in key areas such as contribution limits and flexibility. In this post, we’ll compare the SEP IRA with the Solo 401(k) to help you understand why the Solo 401(k) is often the superior choice for maximizing your retirement savings.
SEP IRA: Simple, but with Some Limitations
The SEP IRA (Simplified Employee Pension) is a straightforward retirement plan designed for self-employed individuals and small business owners. While it offers valuable tax-deferred contributions, there are several factors to consider before deciding if it's the right plan for you.
Contribution Limits
For 2024, the SEP IRA allows you to contribute up to 25% of your net earnings from self-employment, with a maximum contribution limit of $69,000.
The contribution calculation is based on net business income after expenses. For sole proprietors, the contributions are somewhat limited compared to other retirement plans, especially for higher earners who want to save more for retirement.
Eligibility and Setup
The SEP IRA is available to any self-employed individual, sole proprietors, and small business owners. It’s also available if you have employees, although you’ll be required to contribute the same percentage of income to your employees’ SEP IRAs as you contribute to your own, which can be costly.
The plan is relatively simple to set up and maintain, with fewer administrative requirements compared to other retirement options.
Tax Benefits
Contributions to a SEP IRA are tax-deductible, meaning they reduce your taxable income in the year you contribute.
Earnings grow tax-deferred until withdrawals begin at retirement.
Considerations
Contribution flexibility: While SEP IRAs have traditionally been restricted to pre-tax contributions, Secure Act 2.0 now allows for after-tax or Roth contributions to SEP IRAs. This is a huge advantage for those looking to grow their wealth tax-free, as Roth contributions can result in tax-free withdrawals in retirement. However, this flexibility still doesn’t come close to the benefits offered by a Solo 401(k).
Employee contributions: If you have employees, you must contribute the same percentage to their SEP IRAs as you do for yourself, which can become expensive for business owners.
A SEP IRA could make back door Roth contributions taxable due to the pro-rata rule.
Solo 401(k): The Best Choice for Maximum Contributions
The Solo 401(k) is specifically designed for self-employed individuals or business owners with no employees other than a spouse. It offers a much more flexible structure, with higher contribution limits and the ability to choose between traditional or Roth options, making it a standout choice for self-employed individuals.
Contribution Limits
For 2024, as both the employee and the employer, you can contribute up to $69,000 in total, or $76,500 if you're 50 or older (thanks to the catch-up contribution of $7,500).
The Solo 401(k) allows you to contribute as both an employee (salary deferral) and as the employer (profit-sharing). This dual contribution method significantly increases the amount you can contribute to your retirement each year.
Eligibility and Setup
The Solo 401(k) is available to sole proprietors, freelancers, and business owners with no employees (other than a spouse). Setting up a Solo 401(k) requires more paperwork than a SEP IRA, but it’s still relatively simple, especially if you’re working with a financial advisor to set it up.
Tax Benefits
The Solo 401(k) offers traditional (pre-tax) and Roth (after-tax) contribution options. This flexibility is a key advantage as you can decide whether you want to benefit from a tax deduction now or enjoy tax-free withdrawals in retirement.
Traditional contributions reduce your taxable income in the year you contribute, while Roth contributions grow tax-free and allow for tax-free withdrawals in retirement.
Considerations
Higher contribution limits: You can contribute up to $69,000 per year, or $76,500 if you're 50 or older. This is a significant benefit for those looking to maximize retirement savings, especially high-income earners.
Roth option: Unlike the SEP IRA (prior to Secure Act 2.0), the Solo 401(k) allows you to contribute directly to a Roth 401(k), which is an excellent option for younger self-employed professionals who expect to be in a higher tax bracket in retirement. This allows for tax-free growth and tax-free withdrawals in retirement.
Catch-up contributions: If you’re 50 or older, you can contribute an additional $7,500 as part of the catch-up provision, bringing your total contribution to $76,500, helping you accelerate your retirement savings.
SEP IRA vs. Solo 401(k): A Quick Comparison
Feature | SEP IRA | Solo 401(k) |
Contribution Limit | 25% of net income, up to $69,000 | $69,000 ($76,500 if 50+) |
Catch-Up Contributions | No catch-up contributions | $7,500 catch-up contribution if 50+ |
Eligibility | Self-employed or small business owners | Self-employed with no employees (other than spouse) |
Employee Contributions | No contributions from employees | Yes, employees (you are the employee and employer) can contribute |
Roth Option | After-tax or Roth contributions (SECURE Act 2.0) | Yes, can choose between traditional or Roth |
Employer Contributions | 100% employer contributions | Employer contributions (up to 25% of net income) |
The Bottom Line: Consider Your Goals and Needs
Both the SEP IRA and Solo 401(k) have their pros and cons, but for self-employed professionals who are looking to maximize retirement contributions, the Solo 401(k) stands out as the superior option. If you're unsure which plan is right for your situation, we can help. At WealthBound Advisors, we specialize in helping self-employed professionals build customized retirement plans that maximize savings and minimize taxes.
Disclaimer: None of this should be seen as advice. This is all for informational purposes. Consult your legal, tax, and financial team before making any changes to your financial plan.