If you own a business or are a freelance or gig worker, identifying the best path to retirement can be challenging. However, SEP IRA and Solo 401(k)s both cater to the self-employed and offer a simplified way to reach your retirement goals. 

If you’re considering a SEP IRA vs. a Solo 401(k), which one is right for you? We’ll explain the key features of each and provide some scenarios when one may be better suited than the other. 

What Is a SEP IRA?

A Simplified Employee Pension Plan, or SEP IRA, allows small business owners and self-employed individuals to set up and contribute to a traditional retirement account (IRA).  Small business owners also can use a SEP to set up a retirement fund for their employees. 

SEP Benefits

• Simplicity. SEPs are notoriously less labor-intensive than defined retirement plans, such as a 401(k).  
• Well suited to small business owners, sole proprietors, freelance and gig workers. The freedom and flexibility of freelance work can be as attractive as it is lucrative, but without access to an employer-sponsored retirement plan, saving for retirement seems difficult. SEPs are designed, in part, to bridge this gap, giving self-employed workers an easy path to retirement savings.
• Higher contribution limits. You can contribute up to the lesser of $66,000 (2023) or 25% of your adjusted net earnings. This is significantly higher than traditional and Roth IRAs, both of which limit contributions to $6,500 ($7,500 if you’re over 50)
• Tax-deductible contributions. If you’re an employee or self-employed individual taking advantage of a SEP, you can deduct the lesser of $66,000 (2023) or 25% of your adjusted net earnings. As an employer/self-employed worker, you can deduct the lesser of contributions made or 25% of compensation. 

SEP IRA Eligibility

The IRS sets simple eligibility requirements for a SEP IRA: You must be an employer. “Employer” can refer to a sole proprietorship, LLC, S Corp, or C Corp, or you can be a self-employed worker engaged in freelance or gig work. 

SEP IRA Contribution Limits

The 2023 SEP IRA contribution limit is less than $66,000 or 25% of compensation. SEP contributions rules do not allow for catch-up contributions. This is in contrast to traditional and Roth IRAs, both of which allow participants to make catch-up contributions if they are 50 or older. 

What Is a Solo 401(k)?

As the name suggests, a Solo 401(k) is structured similarly to a standard 401(k) you might get through your employer but for an individual. Also known as an individual 401(k), these retirement plans are only available if you’re the only employee. You cannot have a Solo 401(k) if you have employees, though there are exceptions for a spouse that works for you. 

Solo 401(k) Benefits

• Simplicity. Like SEP IRAs, Solo 401(k)s are easy to administer, especially when compared to standard 401(k)s. 
• A Roth option is available. If you have a Solo 401(k), you can choose a traditional or Roth account. Roth accounts allow you to make contributions with after-tax dollars. SEP accounts only allow you to make contributions with pre-tax dollars. You even have the option of converting it to a self-directed 401(k).
• Dual contributions. Solo 401(k)s allow you to make contributions as both the employer and employee. 
• Higher contribution limits. Like SEP IRAs, Solo 401(k)s have higher contribution limits when compared to standard IRAs. 
• Allows for catch-up contributions. If you’re over the age of 50, you can make an additional “catch-up” contribution each year. This is not an option under current SEP rules.  In 2023, the catch-up contribution limit is $7,500. 
• Option to borrow from your account. You can borrow up to $50,000 or 50% of your plan value (whichever is lesser). This option is not available under any IRA plan, including SEP IRAs. 

Solo 401(k) Eligibility

To be eligible for a Solo 401(k), you must be self-employed or a business owner without any employees. Once you hire employees, you will only be eligible for a Solo 401(k) if you have one employee, and it is your spouse.  

Solo 401(k) Contribution Limits

You can contribute up to $66,000 (2023) to a Solo 401(k), with the option to contribute an additional $7,500 if you’re 50 or older. The total contribution limit includes elective deferrals (made as an employee) and non-elective contributions (made as an employer), both of which have their own rules.

• Elective deferrals, or contributions made as the employee, can be made up to 100% of your compensation or earned income, up to the IRS-set annual contribution limit of $22,500 (as of 2023). 
• Employer non-elective contributions can be up to 25% of compensation or, if self-employed, the limits are based on the rate table located in Publication 560, Retirement Plans for Small Business. 

Differences Between SEP IRAs and Solo 401(k)s

SEP IRAs and Solo 401(k)s share a lot of similarities, but there are a few key differences to keep in mind as you compare your options: 

• Contribution limits: Both SEP IRAs and Solo 401(k)s allow for up to $66,000 in annual contributions as of 2023, but only the Solo 401(k) allows for an additional $7,500 catch-up contribution if you’re 50 or older. A Solo 401(k) also expands contribution opportunities to include contributions made by the employer and the employee. Depending on your income, that may provide an increased savings and tax advantage. 

• Eligibility. Solo 401(k)s, and SEP IRAs cater to business owners, sole proprietors, and the self-employed, but only the SEP IRA allows for business growth in the form of hired staff. You cannot maintain a Solo 401(k) if you plan to hire employees, with the only exception being your spouse. 

• Roth option. If you’re opening a Solo 401(k), you can choose between a traditional or Roth account. Traditional 401(k)s allow for pre-tax contributions, while Roth 401(k)s allow for after-tax contributions. You can only contribute to a SEP IRA with pre-tax dollars. 

Examples of When a SEP IRA Is Better than a Solo 401(k)

If you’re self-employed or are a sole proprietor who anticipates hiring employees — even if it’s only a few — a SEP IRA is likely the better option. That’s because hiring employees will make you ineligible for a Solo 401(k).  

In addition, a SEP IRA is also a better option if you do have employees and are looking for a simple path to providing them with a retirement benefit. 

Examples of When a Solo 401(k) Is Better than a SEP IRA

If you don’t plan on hiring employees, a Solo 401(k) can provide the potential to save more over the years when compared to a SEP IRA, depending on your income. And, since you can make dual contributions, you may find that a Solo 401(k) provides an enhanced tax deduction benefit. 

Another reason a Solo 401(k) may be better is if you prefer to fund your retirement account with after-tax contributions. Solo 401(k)s are available as Roth accounts, but SEP IRAs don’t share that same feature. 

Bottomline

SEP IRAs and Solo 401(k)s are both suitable options if you’re a business owner or otherwise self-employed, but which one is right for you will depend on your business and savings goals. Here are a few key things to keep in mind: 

• A SEP IRA allows you to maintain your account even if you hire employees, while a Solo 401(k) is only an option if you’re the only employee or if your only other employee is a spouse. 
• Both SEP IRAs and Solo 401(k)s have higher contribution limits than standard IRAs. The max contribution for each is $66,000 in 2023, while the max contribution for a standard IRA is $6,500 ($7,500 if you’re over 50). 
• Only Solo 401(k)s are available as Roth accounts.  SEP IRAs can only be funded with pre-tax dollars. 
• If you’re unsure which option best suits your needs and future goals, speak to a financial expert who can help identify the correct product.