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Solo 401(k) vs. SEP-IRA

IRA vs 401K

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Roger Wohlner
Updated December 9, 2021
5 Min Read

The ranks of the self-employed had been growing prior to the onset of the COVID pandemic. The pandemic has served to accelerate the growth in the number of self-employed individuals. 

Being self-employed means that you are responsible for saving for your own retirement. There is no company retirement plan to contribute to unless you put one in place. Funding an IRA is a start, but IRAs have relatively low annual contribution limits. 

The two main self-employed retirement plans are the Solo 401(k) and the SEP-IRA. Here is a look at the details of each plan. 

What is a Solo 401(k)? 

A Solo 401(k) is a retirement plan available to a business owner, their spouse if they are involved in the business and any partners in the business. Regular employees are not allowed to contribute. Solo 401(k)s are sometimes referred to as individual 401(k)s or as a one-participant 401(k). 

Just like a 401(k) plan via an employer, employee contribution limits are the same as the annual limits in effect for the year. For 2021 these are $19,500 with an extra $6,500 catch-up contribution for those who are 50 or over at any point during the year. 

In addition to the ability to make employee deferral contributions, there is the opportunity for the business to make profit sharing contributions on behalf of the employee (business owner or spouse involved in the business). This is a way for the business owner to dramatically increase their ability to save for retirement. 

Profit sharing contributions are made by the business and are a deductible business expense. The maximum profit sharing contribution is 25% of the employee’s compensation (including self-employment income). For those who are sole proprietors and who file taxes using Schedule C, this amount may be reduced a bit in some cases due to the way these limits are calculated when self-employment income for a sole proprietor is used versus salary income that would typically be paid to the business owner through an entity like an S-Corp. It is best to consult with a knowledgeable tax professional regarding your situation. 

The maximum overall contribution via employee contributions and profit sharing is $58,000 with an additional $6,500 in catch-up contributions for those 50 or over for 2021. A Solo 401(k) must be established by the end of the calendar tax year. Employee deferral contributions must be made by the end of the calendar year, profit sharing contributions are generally able to be made up to the date the business files its returns, including extensions. 

Solo 401(k)s can be established at most major custodians such as Vanguard, Charles Schwab, Fidelity and a host of others. You are free to invest in stocks, bonds, ETFs, mutual funds and just about any other type of investment available at the custodian. Some self-directed retirement account custodians offer Solo 401(k) accounts that allow for investment in a wide range of alternative investments. Any investments normally prohibited in a 401(k) offered by an employer would be prohibited here as well. 

Other features of a Solo 401(k) include: 

  • Loans from the plan may be available if allowed by the custodian.
  • A Roth 401(k) option may be available if offered by the custodian. 

What is a SEP-IRA? 

SEP stands for Simplified Employee Pension. A SEP-IRA is a form of an IRA that allows the business to make contributions on behalf of the business owner and any employees. As a practical matter, contributing on behalf of a large group of employees can become very expensive for the business. All SEP-IRA contributions are made by the employer, no employee contributions are allowed. These are typically considered deductible business expenses. 

Contribution limits for 2021 are up to 25% of salary or compensation from self-employment (Schedule C income) up to a maximum of $58,000 for 2021. The account can be opened, and contributions can be made up until the date you file your tax return for the business including any extensions. As with a Solo 401(k), the maximum percentage contribution may be reduced for those whose business income is derived from being a Schedule C sole proprietor. Again consult with a knowledgeable tax professional if this is your situation. 

SEP-IRAs are generally available at most custodians including Vanguard, Charles Schwab, Fidelity and a host of others. For the most part any investment available to an IRA account holder is available via a SEP-IRA. This includes stocks, bonds, ETFs, mutual funds and others. Some self-directed retirement account custodians offer SEP-IRA accounts that allow for investment in a wide range of alternative investments. Any investments normally prohibited in an IRA account would be prohibited here as well. 

A few other points regarding SEP-IRA accounts include: 

  • Loans are not available from a SEP-IRA.
  • There is no Roth option available for a SEP-IRA.
  • There are no additional catch-up contributions for those who are 50 or over.
  • If your salary or income from the business is limited in a given year, this will limit the amount you can contribute to the SEP-IRA for that year as contributions are based on a percentage of your salary or self-employment income. 

Solo 401(k)s and SEP-IRAs compared 

Both the Solo 401(k) and the SEP-IRA are solid retirement plan choices for those who are self-employed. Here is a comparison of the similarities and differences in the two plans. 

Solo 401(k)SEP-IRA
Business owners, spouses involved in the business and business partners.
Business owners and employees. Employees who are at least age 21, who earn at least $600 and who have worked for the company for at least three of the past five years are generally eligible to participate.
Employee contributions
Yes – up to annual 401(k) limits
Employer contributions allowed?
Maximum total contributions - 2021
$58,000 - $64,500
Roth option
Loans available
Deadline to open
End of calendar year
Date that business tax return is due including extensions.

Who Should Choose Solo 401(k)? 

A Solo 401(k) is generally a better option for those who want a retirement account with a bit more flexibility and the option to make employee contributions. 

Generally, a Solo 401(k) will allow higher combined employer and employee contributions at lower levels of income. Here is a look at the maximum combined employee and employer contributions at various levels of owner compensation from the business. 

Owner compensationSolo 401(k)SEP-IRA
$50,000 – younger than 50
$50,000 – age 50 or older
$100,000 – younger than 50
$100,000 – age 50 or older
$154,000 – younger than 50
$154,000 – age 50 or older
$232,000 – younger than 50
$232,000 – age 50 or older

Note that in this chart you can see that the ability to fully max out combined contributions to a Solo 401(k) comes at an income of $154,000 versus at $232,000 for a SEP-IRA. These numbers are based on the employee and employer contribution limits for 2021.   

If you are looking for the ability to contribute to a Roth 401(k) account, a Solo 401(k) offers this option as well. You can generally make up to the maximum level of employee contributions to a Roth option. However, all employer profit sharing contributions must be made to a traditional 401(k) account. 

Loans are permitted from a Solo 401(k) offering another level of flexibility. 

Who Should Choose a SEP-IRA? 

The ability to open and fund a SEP-IRA account as late as the date your business return is due for the prior tax, including extensions, offers a high level of flexibility for business owners. If this type of flexibility is important to you then a SEP-IRA may be beneficial. 

If your company has non-owner employers then a SEP-IRA is the better of the two options. That said, it is important to remember that you will be required to fund the employee’s accounts at the same percentage of compensation that you fund your own account. This can get expensive. There may be other types of small business retirement accounts that are more cost effective for you. 

SEP-IRAs generally require less paperwork than a Solo 401(k) and are usually very easy to open at most custodians. There are generally fewer reporting requirements for a SEP-IRA than with a Solo 401(k). 

Where to go from here? 

The next steps are to review your situation and determine which type of self-employed retirement account is best for you. If you work with a financial advisor or a tax professional they can provide guidance to help you make the best decisions for your business. 

After you’ve decided upon the best type of retirement plan for your situation, the next step is to choose the best custodian to open your account at. Factors to consider might include: 

  • Are there any restrictions on what you can invest in? Would these restrictions impact your planned investments?
  • Any fees or costs associated with the account at the custodian. This might include investment minimums, transaction costs, annual fees and others.
  • Does it make sense to use a custodian where you might have other investment accounts in order to keep everything in one place? 

If you are working with a financial advisor they will likely have ideas about which custodian to use and how to invest this money. The latter decision should ideally be made in line with the rest of your portfolio and based on your time horizon until retirement and your risk tolerance.