Blog: Solo 401k vs SEP IRA For Self-employed

Are you self-employed and want to invest your savings while lowering your taxes? Maybe you’re a realtor, interior designer, or a TikTok influencer, and you want to finally create your own retirement plan. Is Solo 401(k) or SEP IRA better for you? In this article, I’m going to share a side by side comparison of the Solo 401(k) vs SEP IRA. These are the two most popular ways you can save if you’re self-employed.

Round #1

Who can participate in Solo 401(k) and SEP IRA?

So let’s say you’re a TikTok influencer. You just hit 1 million followers. Your income from ads and sponsorships are coming in and you want to invest that money wisely. The good news is you can contribute to either a solo 401(k) or SEP IRA. But the very important difference is this:

With a solo 401(k), you can contribute both as the employer AND employee. With a SEP IRA, you can only contribute as the employer. Why should you care?

If you’re the only one in the company, you’re not going to care, since you’re both the employer and employee. But if you have a W2 employee, say you hired a virtual assistant to help you out, you cannot contribute to a solo 401(k). That’s why they call it a solo 401(k). You need to be flying solo. If you have contractors who are 1099 employees, you can still contribute to a solo 401(k).

Here is one important consideration for the SEP IRA: Because you’re contributing as the EMPLOYER, if you contribute 10% of your income to your SEP IRA and you have a W2 employee, then you as the Employer are also required to contribute 10% of your employee’s income into his/her SEP. The contribution has to be equal across the board.

Round 1 Winner: It’s a tie. You can use both if you’re self-employed. There is also a con to both if you have a W2 employee.

Bonus Question: What if you’re a TikTok influencer, and you set up an S Corp. Can you set up a solo 401(k) for S corporations?

Answer: Yes. If you’re a sole proprietor, S Corp, LLC or C Corp, and you don’t have W2 employees, you can contribute to a solo 401(k).

Round #2 

Solo 401(k) vs SEP IRA: What are the Contribution Limits?

For both solo 401(k) and SEP IRA, as the Employer, you can contribute up to 25% of your compensation, up to a maximum of $57,000 for the 2020 tax year and $58,000 for the 2021 tax year. Based on my experience, after certain deductions and adjustments, it comes to slightly above 18% of my compensation. Work with a tax accountant to get the exact percentage right.

This is where you get to really take advantage of being a small business owner. For most people working as a regular employee, contribution limits are less than half that amount, $19,500 for 2020 and 2021.

So the employer solo 401(k) contribution limit for 2020 and 2021 and SEP IRA contribution limit for 2020 and 2021 is the same. Now, if you have a solo 401(k), you can also contribute as the employee! The employee solo 401(k) contribution limit for 2020 and 2021 is $19,500 for employees under 50 and $26,000 for employees age 50 or older.

For example, if you’re a realtor and you made $200,000 in 2020 with the help of the crazy hot real estate market, you can contribute approximately 18% of 200,000 as the employer in either a solo 401(k) and SEP IRA. That’s $36,000 that you get to invest and deduct from your taxes. But with a solo 401(k), you can contribute an additional $19,500 as an employee! That’s a total of $55,500!

Round 2 Winner: Solo 401(k) wins because of that additional $19,500 employee contribution allowed.

Round #3

When is the Contribution Deadline for Solo 401(k) and SEP IRA?

For 2020, the contribution deadline for the Solo 401(k) as well as the contribution deadline for the SEP IRA has been extended to May 17, 2021. This deadline is specifically for the employer contributions.

If you’re setting up a solo 401(k) just now for the tax year 2020, you cannot contribute as an employee, unfortunately. But you can do so for the tax year 2021. The takeaway is you still have time to create and put in money to either a solo 401(k) or a SEP IRA, as the Employer. Make sure you do this before the deadline. Take a break from uploading your TikTok video for a day!

Round 3 Winner: It’s a tie. The Solo 401(k) contribution deadline and SEP IRA contribution deadline are the same.

Round #4

Which is better for taxes: Solo 401(k) or SEP IRA?

Say you’re an interior designer and you contribute to a SEP IRA. You get to deduct those contributions from your tax return. But once you withdraw from your SEP IRA during retirement, you’ll have to pay federal and maybe state taxes on the amount you withdraw.

For a solo 401(k), you can usually choose the tax treatment. If you want to take the tax deduction now, you can contribute to a traditional solo 401(k). If you want to let your money grow tax-free, you can contribute to a Roth solo 401(k). You pay the taxes now, but when you withdraw from a Roth solo 401(k) during retirement, you don’t pay a single dime in taxes.

Round 4 Winner: Solo 401(k) wins again.

Round #5

How easy is it to set it up and maintain a Solo 401(k) or SEP IRA? 

They’re both actually easy to set up. When you open a solo 401(k), the provider will usually create a solo 401(k) plan document for you. There are several solo 401(k) providers you can choose from. If you’re a fan of Vanguard, you can create a Vanguard solo 401(k). You can also create a Fidelity 401(k) or ETrade solo 401(k). One downside with a Vanguard solo 401(k) is it does not allow you to roll over an existing IRA into your Vanguard solo 401(k). For about 2 years, I kept calling Vanguard to ask if they will allow this feature soon. We got tired of waiting and ended up opening another solo 401(k) with Etrade. One downside with a Fidelity solo 401(k) is it does not have a Roth 401(k) option.

If you’re setting up a SEP IRA, it’s pretty straightforward to do so via Vanguard or Fidelity or ETrade.  A lot of people forget this next step though. You will need to complete a Form 5305-SEP. It’s just half a page long. No need to file with the IRS. This form officially creates your SEP IRA plan.

How easy is it to maintain: Solo 401(k) vs SEP IRA? Both are easy. However, with a solo 401(k), once the plan’s assets reach $250,000, you’ll need to file a Form 5500 each year to remain in compliance with IRS rules.

Round 5 Winner: SEP wins, since there’s a bit more paperwork with a 401(k).

Who wins overall?

There are two ties. The solo 401(k) got 2 points. The SEP IRA got 1 point. Solo 401(k) wins our match!

About Alvin Carlos, CFA, CFP®

Alvin Carlos, CFA, CFP® is passionate about helping middle class professionals make smarter financial decisions. He is the CEO of District Capital Management, a financial planning and investment management firm for the everyday people. Alvin is a CERTIFIED FINANCIAL PLANNER™ practitioner and has a Masters degree in International Relations from SAIS-Johns Hopkins. In his spare time, Alvin enjoys swing dancing and Ultimate Frisbee. He also volunteers for Catholic Charities’ new Financial Stability Network, which helps low-income folks with their finances.

View all posts by Alvin Carlos, CFA, CFP®