SEP IRA vs. Solo 401(k): Differences for Self-Employed People

Without the benefit of an employer-sponsored retirement plan, such as a company 401(k), self-employed individuals are responsible for their own retirement savings strategy.

Thankfully, they have options. The SEP-IRA and Solo 401(k) can offer both tax benefits and investment opportunities to help better prepare for the retirement years.

Here’s a look at the differences between these two types of retirement savings vehicles, who is eligible for them, and what they entail.

What is a SEP IRA?

A simplified employee pension (SEP) plan is a retirement account available to businesses of any size, including sole proprietors with no employees. With a SEP plan, a business opens and funds traditional individual retirement accounts (IRA) for each eligible employee in the company—including the owner—without the complexity and added expense that often comes with 401(k) plans.

SEP IRAs may only be funded by an employer; employees may not make their own contributions. Additionally, the employer must fund all eligible employee plans equally, by the percentage of salary. That means that if the business owner contributes 10% of their salary to their own SEP-IRA account, they must contribute 10% of each employee’s salary to their accounts as well.

SEP IRAs come with several benefits for participants. Employer contributions into SEP IRAs are fully vested, meaning that the employee owns all of the funds from day one. The individual account holder, not the employer, decides how to invest the funds—be it in target-date funds, exchange-traded funds (ETFs), mutual funds, or even individual stocks. The account holders can also roll the money into another IRA at any time.

With a SEP IRA, employees are bound to the typical IRS rules for traditional IRAs: funds can be withdrawn without penalty starting at age 59½  and required minimum distributions (RMDs) begin at age 72.

What is a solo 401(k)?

A solo 40(k) is a retirement savings account available to self-employed individuals with no employees. Solo 401(k) plans are simply traditional 401(k) plans that only cover a business owner, or the owner and their spouse. With a solo 401(k), a business owner can participate as both the employer and the employee, potentially amplifying their retirement savings efforts. However, they must follow the same requirements as standard 401(k) plans and will need to meet all of the same 401(k) rules set by the IRS, such as maintaining fiduciary duty and passing annual nondiscrimination tests.

What are the main differences between SEP IRA and Solo 401k?

While the tax advantage is similar, SEP IRAs and Solo 401(k)s have many differences—namely: eligibility limitations, obligations to others, and contribution limits.

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What are the benefits and limitations of SEP IRAs?

With high contribution limits and flexible policies, SEP IRAs can be quite beneficial for small business owners with no employees. But perhaps the greatest advantage is ease. “As a sole proprietor,” explains Titan retirement specialist Eddie Lopez, “you’re someone doing everything by yourself. It’s a big responsibility. That’s why the SEP IRA has become so attractive—because it's easy to set up and very easy to administer.”

Of course, there are limitations. For example, SEP IRAs—like all IRAs—don’t allow loans. 

Benefits of SEP IRAs

• SEP IRAs potentially allow for a greater savings rate compared to other IRAs.

  While traditional IRAs and Roth IRAs have annual contribution limits of $6,000 in 2022 (or $7,000 with the catch-up contribution), SEP IRAs allow for up to 25% of the account holder’s salary or $61,000—whichever is less—in annual contributions.

• They are less costly and complex than 401(k)s—even solo 401(k)s.

  The typical 401(k) retirement plan has many IRS requirements and can be costly and complex to maintain. For instance, employer plans have to pass nondiscrimination tests on an annual basis, to ensure that their 401(k) is fair and balanced. Overseeing this compliance requirement requires time and resources, and often requires a dedicated team. A SEP IRA, on the other hand, is flexible, doesn’t require the same IRS testing, and typically has lower administrative costs.

• Employers aren’t required to contribute each year.

  An employer can choose to contribute or not contribute to SEP IRAs on an annual basis, allowing them to make that determination according to the company’s performance and revenue that year. With a traditional 401(k) plan, on the other hand, employers are required to follow through on any contribution standards or matches that are part of the established plan—regardless of how the company is performing. Changes require a formal restructuring of the plan.

• Contributions can experience tax-deferred growth.

  Unlike other investments, such as stocks and many mutual funds, the contributions that grow in a SEP IRA do so without any annual tax implication. Account-holders only pay income tax on the funds in retirement, when the funds are withdrawn.  

Limitations of SEP-IRAs

• Equal contributions are required.

  Employers are required to give every eligible employee the same SEP IRA contribution that they give themselves (or any other employee), calculated as a percentage of their wages.

• Only employers can contribute.

  Regardless of who is participating in a SEP IRA plan or how many employees are involved, the company is usually the only one that can contribute to the plan. Employee elective deferrals are not allowed in recently-established SEP IRAs; SARSEP plans, which were established prior to 1997, did allow for employee contributions, and existing participants may still be grandfathered in. However, new plans no longer offer this option. 

• Employee eligibility cannot be restrictive.

  The IRS sets certain maximum requirements for SEP-IRA participants. These include requiring the employee to make more than $650 annually, be age 21 or older, or have worked for the company for at least three of the last five years. While employers can set less restrictive guidelines, they cannot exceed the IRS limits with more restrictive requirements.

• Employees are 100% vested.

  Rather than requiring employees to vest their employer contributions over time, all funds added to a SEP IRA are owned by the employee from day one. These benefits employees, but may be a limitation to business owners who want retirement plan contributions to incentivize retention.

• No loans.

  IRAs don’t come with the loan providers that 401(k)s do. This means that account holders who want to make early withdrawals from their IRA won’t be able to pay those funds back, and might be faced with a penalty for doing so.

What are the benefits and limitations of a solo 401k?

Of course, solo 401(k) plans also have their own advantages and disadvantages.

Benefits of a solo 401(k)

• Contributions can come from both sides.

  Business owners can contribute to their solo 401(k) plan as both the employer and the employee. This not only increases the total contribution allowed, but also offers its own tax advantages.

• Contributions aren’t as limited by compensation.

  With a SEP IRA, participants are limited to the lesser of the annual contribution limit or 25% of their total compensation. With a solo 401(k), though, the employee side of the contribution—whose maximum is $20,500 ($27,000 with the catch-up contribution)—isn’t limited by compensation.

• Catch-up contributions are allowed.

  Unlike SEP IRAs, solo 401(k) plans allow for catch-up contributions if the self-employed individual (or their spouse) is age 50 or older. These catch-up contributions allow for up to an additional $6,500 in annual contributions for 2022.

• Loans are allowed.

  IRAs do not allow participants to take out loans from their account balance, and SEP IRAs are no exception. However, 401(k) plans do allow for loans, and this includes solo 401(k)s.

Limitations of a solo 401(k)

• Only self-employed people with no employees are allowed.

  Solo 401(k) plans are only offered to sole proprietors or small business owners without employees (excluding the owner’s spouse). If the business has other employees, a traditional 401(k) plan, SEP IRA, or other retirement options will be necessary.

• They are more complex.

  While solo 401(k)s are simpler to manage than the typical corporate-sponsored 401(k), they still must meet certain IRS requirements, such as nondiscrimination testing. This makes them more complex and costly to manage than an IRA.

• Contribution limits can be tricky.

  While the overall contribution limit of a solo 401(k) plan is comparable to that of a SEP IRA, this limit is divided between the employee’s side of that contribution and the employer’s side. This means that business owners will have to split their contributions accordingly, ensuring that their paperwork is all in order come tax time.

Can a business owner have both plans?

A sole proprietor with no employees can technically have both a SEP IRA and a solo 401(k), and can contribute to both as part of their retirement savings strategy. However, the total maximum applies to the aggregate amount contributed to both plans.

With that said, if an individual owns more than one business, they can utilize both a SEP IRA and a solo 401(k) to maximize their retirement savings by splitting the accounts between the businesses. They just may need to work with a financial or tax professional to be sure that their SEP-IRA and solo 401(k) contribution limits are not exceeded.

Bottom line

Retirement saving plans are an important, but often complex, part of planning for the future. This is especially true for those who are self-employed, whether they work as a sole proprietor or have employees.

Both solo 401(k) plans and SEP-IRAs offer retirement savings options for self-employed individuals. Choosing the right one depends on factors like compensation, number of employees, and the intended contribution amount.