Solo 401k vs SEP IRA: Which Should You Choose for Your Business?

Solo 401k vs SEP IRAOne of the most common questions I see from new entrepreneurs is about their retirement plan options. Specifically, I see a lot of people talking about the Solo 401k vs SEP IRA. Today I’m going to explain what those two plans are, show you the differences, and share why I chose the Solo 401k.

In short, I find that the SEP IRA is the perfect tool for the part-time entrepreneur (someone who has a small business, but is still eligible for a 401k through their full-time employer). The Solo 401k, on the other hand, is great for anyone who is fully self-employed in a one-person business.

But there is obviously more to it than that. We need to look at the tax and administrative differences, in both the short and long terms. Let’s dig into each of these accounts first so you can fully understand the differences.

The Solo 401k

The Solo 401k is just what it sounds like: a 401k plan (i.e. tax-deferred retirement plan) for an individual. The individual’s business cannot have employees other than an employed spouse. The owner’s spouse can participate in the Solo 401k if an employee of the business.

In many ways, the Solo 401k acts just like a regular 401k you would get through an employer. Contributions to a Solo 401k are not taxed (i.e. they help reduce taxable income) when they are contributed. Money can be withdrawn from the Solo 401k without penalty in retirement (at age 59.5), when regular income taxes will be paid on the money withdrawn.

Depending on the provider of the plan, you might be able to borrow money from your Solo 401k, up to $50,000 or 50% of the value, whichever is less. And many providers will allow you to choose from a wide variety of investments options (cash, CDs, stocks, bonds, funds, etc.) within your 401k.

But the Solo 401k has it’s unique qualities as well. Because you are both the employer and the employee in your business, you can contribute both the employer’s and the employee’s (salary deferral) portions to the Solo 401k.

The employee’s contribution limits fall in line with regular 401k limits, which are $17,500 for 2013. Note that these contributions are shared with any other 401k contributions you are making.

The employer’s contribution limits are set at 25% (or 20% if a sole proprietor or single-member LLC) of the compensation you pay yourself, up to a total contribution (including the employee’s portion) of $51,000 in 2013.

A Solo 401k must be established prior to year end to make contributions for that year.

A special feature I’m just learning about is the ability to take some of the employee’s contribution and designate it as a Solo Roth 401k contribution. I’m not sure of how many providers will allow this, but it’s certainly another advantage of the Solo 401k if possible for you.

The SEP IRA

The Simplified Employee Pension Individual Retirement Arrangement (SEP IRA) is very similar to a traditional IRA. A business owner with or without employees can establish a SEP IRA.

Contributions to a SEP IRA are deductible and grow tax deferred until retirement (at age 59.5), when regular income taxes will be paid on the money withdrawn. You cannot borrow from a SEP IRA. Most SEP IRA providers will allow you to pick from a big menu of investment options to have within your SEP IRA.

There is no employee deferral contribution to a SEP IRA. All of the contributions must come from the employer. Still, the maximum contribution is the same as the Solo 401k: 25% of compensation, up to $51,000 for 2013.

A SEP IRA must be established before the tax deadline to make contribution for that previous year.

Other Small Business Retirement Plans

These are not the only two retirement plans available to small business owners. Although they are very common. Others include the SIMPLE IRA plan, regular 401k, or a regular Roth or traditional IRA. Be sure to sit down with a CPA or other professional to determine which particular plan is right for you.

Why I Choose a Solo 401k vs SEP IRA

Ultimately I chose a Solo 401k because I was no longer employed by someone else and I didn’t have access to a regular 401k. I missed being able to defer tens of thousands of dollars in income each year. If I was still employed by someone else and working on my business part-time I would likely use a SEP IRA.

I also liked that I could add my wife to the plan at some point, which I’ve done since. Mostly I liked that I could contribute as an employer and an employee for a really large contribution.

Lastly, I would say that I liked that Vanguard offered an easy-to-setup Solo 401k plan that was fee-free for me since I’m at their Voyager service level. Here’s what some others had to say:

Twitter Solo 401k vs SEP IRA

Answers from Twitter about the Solo 401k vs SEP IRA.

What about you? Which plan do you think is right for you? If you already have a plan, which plan do you use and why?



Last Edited: June 10, 2013 @ 4:55 pm
About Philip Taylor

Philip Taylor, aka "PT", is a husband and father of two. He created PT Money back in 2007 to share his thoughts on money and to meet others passionate about managing their finances. All the content on this blog is original, and created or edited by PT. Read more about Philip Taylor, and be sure to connect with him on Twitter, Facebook, or view the Philip Taylor+ Google profile.

Comments

  1. This is a great overview. I’m not currently self-employed so I have an individual Roth and then an employer sponsored 401k. These are working well so far, but I hope to eventually be self employed, so this knowledge will come in handy. Thanks.

    • Thanks, Jake. You know, I know several part-time entrepreneurs who use the Roth, 401k, and a SEP IRA (i.e. the trifecta) to max out their contributions.

  2. I opened a solo 401k with Vanguard because of the high limits and the low fees. I could have contributed to a 401k with my employer but I with the solo 401k I can make after-tax contributions with my Roth 401k and the fees for John Hancock funds (through my employer) are quite ridiculous.

  3. I’ll be looking into this next year. The main goal this year is to knock out student loans as much as possible, so there won’t be any business income available to contribute.

    • I like your focus, Lance. I bet you knock them out sooner than you think. The good thing about the Solo 401k is that you can open it up on Dec 31 and you have until you file taxes to contribute the employer portion. Very flexible on the start.