If you’re self-employed, you’ve likely encountered the overwhelming amount of information online about SEP IRAs vs. Solo 401(k) plans. While these articles may be full of facts, they often fail to simplify the nuances of self-employment for those who don’t work in finance.
The truth? Navigating business-sponsored retirement plans can get complicated fast. Instead of covering every possible scenario, let’s focus on what matters most for solo entrepreneurs like you. Whether you're a freelancer, consultant, or solo business owner earning 1099 income, this guide will help you make sense of SEP IRAs and Solo 401(k) plans.
Let’s dive in!
What are SEP IRA and Solo 401(k) plans?
SEP IRA and Solo 401(k) plans are tax-advantaged business retirement plans. They’re both available to solo entrepreneurs. They offer ways to save for retirement while lowering your taxable income.
Contribution Limits (2024 & 2025 Updates)
Solo 401(k) generally has a higher contribution limit than SEP IRA. If you want to put away more money, then Solo 401(k) would be a better solution.
SEP IRA
For a SEP IRA, a self-employed entrepreneur can contribute up to about 20% of the earnings or $69,000 for 2024 or $70,000 for 2025 (whichever is less). Importantly, only the employer can contribute to a SEP IRA, let’s call this the profit sharing portion of contribution. We’ll talk about it in the Solo 401(k) section too.
You'll read in many places that you can put away 25% of your wage, but it's not true for self-employed people because we are special, and we have special rules :) (unless you have an S-Corp, which we’ll discuss below in examples). For curious-minded people, IRS publication (page 34-35)
Unlike Solo 401(k)s, SEP IRAs don’t have an employee deferral option or catch-up contributions for those over 50.
Solo 401(k)
As solo entrepreneurs, we are one-person businesses. However, when it comes to Solo 401(k), we have two roles - the employee and the employer (yes they’re both you).
For 2024, a Solo 401(k) participant can make an employee deferral of the lesser of $23,000 or your earned income (or another $7,500 on top of that for those aged 50 or older due to catch-up contributions).
In addition, the business can make a profit-sharing contribution that has a very specific formula for self-employed individuals, which is typically 20% of your self-employed net income (as opposed to 25% of compensation that you would likely read in other places).
You need to make sure that both employee deferral and profit sharing combined are below $69,000 a year in 2024 (similar to SEP IRA). If you’re over 50, you can have another $7,500 of catch-up contribution while SEP IRA doesn’t allow that since there’s no employee deferral portion.
In 2025, deferral is capped at $23,500 with the total contribution being $70,000.
Basically, SEP IRA can only make the profit-sharing contribution while Solo 401(k) allows you to make employee deferral in addition to profit sharing. So you can most likely contribute more with a Solo 401(k).
Example
You’re a 1099 consultant with net income of $150,000 a year in your late 30s.
Solo 401(k): A total of $50,881: Employee deferral- $23,000 and profit sharing - $27,880
SEP IRA: A total of $27,880 because SEP IRA is profit sharing only.
S- Corp Example
S-Corp is a common tax-saving strategy for solo entrepreneurs. One thing to consider is that your definition of compensation changes to your W2 wage when you have an S-Corp, While S-Corp can be beneficial in tax savings, it can limit how much you can put away.
With the similar example above, instead of $150,000 of net income, now you’re a solo S-Corp owner making $50,000 in W2 salary and your business has profit of $100,000.
Solo 401(k): A total of $35,500: Employee deferral - $23,000 and profit sharing - (now 25% of your W2 wage) $12,500.
SEP IRA: A total of 25% of your W2 wage $12,500.
Either way, Solo 401(k) comes ahead regarding maximum contribution.
Eligibility
Solo 401(k)
As the name suggests, this is only for solo entrepreneurs. One exception is if your spouse works with you. But that’s about it. If you have other employees, Solo 401(k) is off-limits.
SEP IRA
Any employer can adopt SEP IRA. If you plan on hiring employees soon, SEP IRA might make more sense than a Solo 401(k).
Others
Administration
By in large, it's easier to set up a SEP IRA than a Solo 401(k). You can go to a brokerage to open up SEP IRA, wherever available. You must file IRS file 5305, but it's typically taken care of for you. On an ongoing basis, operating a SEP IRA is pretty easy and inexpensive.
There’s more paperwork involved in Solo 401(k), it also takes longer. YOU MUST HAVE AN EIN (Employer Identification Number) to set up Solo 401(k). There are places where you can set up a Solo 401(k) for free; however, you'll typically need to pay a small fee to set up and on an ongoing basis if you want to access "premium" features such as Roth (pay tax now, tax-free later) option or the loan option.
In either case, please inform your tax professional that you make these contributions.
Roth Option
Before SECURE ACT 2.0, SEP IRA didn’t offer a Roth option, meaning you can only make pre-tax contributions (get tax deduction now, pay tax when you withdraw). Solo 401(k) technically all have Roth option, but you might need to pay a small fee to access that, as mentioned above.
Post SECURE ACT 2.0, SEP IRA does have Roth option nowadays. Well, technically. As of this newsletter issuance, I have yet to be made aware of anywhere that actually offers a Roth option for SEP IRA. Here's hoping for 2024.
So if you want the Roth option, your best bet is still Solo 401(k).
Pro Rata Rule for Backdoor Roth
This is a level-up section, so feel free to skip if your head is already spinning, or if you're unfamiliar with Backdoor Roth, we'll discuss this separately in a future issue.
If backdoor Roth is important to you in anyway, Solo 401(k) would be a better bet because you are not subject to the pro-rata rule with money in Solo 401(k). However, if you have a pre-tax SEP IRA, your pre-tax IRA will be included in the consideration for the aggregate of IRA when you perform Backdoor Roth. I know that's a lot of jargon, but all you need to know is that you might be surprised with a tax bill you didn't expect because the IRS looks at all of your IRA when they tax your Roth conversion. You can learn more here about Backdoor Roth and Pro-rata rule.
Conclusion
Solo 401(k) and SEP IRA plans offer valuable tax-advantaged retirement savings options for self-employed individuals and small business owners. While Solo 401(k) wins in various situations, a SEP IRA may be a better fit if you prefer simpler administration or you have immediate hiring plans.
Please remember that this is for educational purposes, and your situation might differ. So please consult a financial planner if you have any questions.
Cheers,
Lei
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