Nuts & Bolts: Solo 401(k)s and SEP IRAs

For self-employed individuals, freelancers, and small business owners without full-time employees, securing the right retirement plan can be challenging. Two popular options are often put up by plan providers: the Solo 401(k) and the Simplified Employee Pension IRA.

Eric Droblyen, president and CEO at Employee Fiduciary, LLC, says 401(k) plans are becoming more versatile, including for this self-employed workforce, because of new rules being implemented from Secure 2.0.

“Secure 2.0 allowing for the Rothification of employer contributions is useful because a lot of people can now use a solo 401(k) to do a mega backdoor Roth with voluntary contributions,” he says, referring to a strategy to make after tax account investments. “401(k) plans in general are just getting a lot more flexible. And the SEP IRAs are really just a conduit for making IRA contributions.”

Below are breakdowns of the two offerings.

Solo 401(k)

A Solo 401(k), also known as a one-participant 401(k), allows for high contribution limits and offers significant flexibility in terms of plan design.

“They’re basically a 401(k) plan that just covers owners and their spouses,” Droblyen says. “Because they don’t cover any non-owners, they’re not subject to a lot of the annual administration requirements that a 401(k) plan typically has to complete testing.”

Because the plan only covers the business owner and spouse, it is exempt from nondiscrimination testing and top-heavy rules, making administration easier. Moreover, if the plan’s assets are under $250,000, there is no need to file a Form 5500.

Another benefit of a Solo 401(k) is its generous contribution limit. In 2024, participants can contribute up to $69,000, with an additional $7,500 catch-up contribution for those aged 50 or older, the IRS stated. Solo 401(k) plans also provide flexibility in contribution choices, offering both pre-tax and Roth options.

However, there are some restrictions. Solo 401(k) plans lose their status if the business hires full-time employees other than the owner or spouse, triggering the need to comply with more complex 401(k) regulations.

SEP IRA

The SEP IRA is another popular retirement savings plan for self-employed individuals, freelancers, and small business owners. The SEP IRA typically requires minimal paperwork, making it a cost-effective option for entrepreneurs. Recordkeeping fees are generally lower for SEP IRAs compared to Solo 401(k)s.

“For SEP there’s no employee contributions allowed,” Droblyen says. “Everybody has to get the same rate. You can’t have loans. There’s just a way for an employer to contribute to an IRA on behalf of the employee.”

In a SEP IRA, contributions must be made for all eligible employees, and each employee must receive the same percentage of compensation as the employer. This makes the SEP IRA a more straightforward plan for business owners with employees compared to the Solo 401(k), which is limited to business owners without full-time staff. Droblyen notes that a SEP IRA, however, can become very costly for employers.

“A big drawback with SEP is you have to allocate the same contribution rate for everybody,” he says. “If the owner wants a 20% contribution, they’d have to allocate a 20% contribution to the other participants, and that could get expensive.”

The SEP IRA also allows for significant contributions. According to the IRS, in 2024, SEP IRA contributions can be made up to 25% of net income or $66,000, whichever is lower. 

Choosing a Plan

When choosing between these two plans, For Us All offered a few key factors to consider. The Solo 401(k) offers more flexibility in terms of contribution types and higher limits, making it ideal for high earners who want to maximize their retirement savings. It’s also a good choice for business owners who do not plan to hire employees, as the plan’s simplicity and lack of complex Internal Revenue Service testing requirements make it easy to manage.

The SEP IRA is simpler to set up and administer, making it a good option for entrepreneurs who prioritize ease of use and lower administrative costs. It’s also a better choice for business owners with employees or those who plan to expand their business in the future. Since the SEP IRA allows contributions for employees, it provides an easier solution for growing businesses.

Both plans come with favorable tax advantages. Contributions to a Solo 401(k) or SEP IRA are generally tax-deductible, reducing the business owner’s taxable income for the year. Additionally, both plans have deadlines tied to tax filings, giving business owners flexibility in deciding when to establish and contribute to their plans. The SECURE Act extended the deadlines for both plans, allowing business owners to adopt a Solo 401(k) or SEP IRA up until their tax filing deadline, including extensions.

Ultimately, the choice between a Solo 401(k) and a SEP IRA will depend on the business owner’s income level, business structure, and future growth plans. High earners who want maximum flexibility and the ability to contribute both as employees and employers may find the Solo 401(k) more beneficial. On the other hand, those seeking a simpler, low-maintenance retirement plan, especially if they have employees, may prefer the SEP IRA.