SEP IRA or Solo 401(k)?

Let’s do this in a Q&A format to make it easier to move through.

What are SEP IRAs (aka Simplified Employee Pension Individual Retirement Account)?

They are a retirement savings account you can set up if you are self-employed. Contributions are tax-deductible, and they grow tax-deferred, meaning you don't pay taxes on the investment gains until you withdraw the money in retirement. Withdrawals are then taxed as ordinary income. The maximum contribution is generally the lesser of 25% of your compensation or $58,000. Like other types of IRAs, SEP IRAs offer a variety of investment options, including stocks, bonds, mutual funds, and more.

What are solo 401Ks (aka an Individual 401(k) or a One-Participant 401(k))?

They are a retirement savings plan designed for self-employed individuals with no employees other than themselves and, if applicable, their spouse. One of the primary advantages of a Solo 401(k) is its higher contribution limits compared to other retirement plans for the self-employed, such as a SEP IRA. As both the employer and employee, a self-employed individual can make contributions to their Solo 401(k). Employee contributions are made on a pre-tax basis, reducing taxable income, while employer contributions are tax-deductible for the business. They offer a range of investment options, such as mutual funds, stocks, bonds, and other securities.

Can I have both?

Yes! Though there are a few considerations:

  1. The combined contribution limits apply across all your retirement accounts. For example, if you contribute to both a SEP IRA and a Solo 401(k), the total contributions made to both accounts cannot exceed the annual contribution limit set by the IRS.

  2. Managing both a SEP IRA and a Solo 401(k) may mean more administrative responsibilities, including record-keeping, compliance with IRS regulations, and potentially higher costs.

  3. SEP IRAs and Solo 401(k)s may offer different investment options, so having both accounts could provide you with a broader range of investment choices to diversify your retirement savings.

  4. Contributions to both a SEP IRA and a Solo 401(k) offer tax benefits, but the specific benefit may vary. For example, contributions to a SEP IRA are generally tax-deductible for the employer, while contributions to a Solo 401(k) can be made on a pre-tax or Roth (after-tax) basis, depending on the plan.

Which is better?

Here are a few things to consider:

  1. Contribution Limits: Solo 401(k) plans generally allow for higher contribution limits compared to SEP IRAs. If you're looking to maximize your retirement savings (i.e. you started contributing later in life), the Solo 401(k) may offer greater potential for higher contributions.

  2. Employer Contributions: SEP IRAs are funded solely by employer contributions, while Solo 401(k) plans allow for both employer and employee contributions. If you want the flexibility to make both types of contributions, a Solo 401(k) might be preferable.

  3. Administrative Complexity: SEP IRAs are relatively simple to set up and maintain, with fewer administrative requirements compared to Solo 401(k) plans, which may involve more paperwork and potentially higher administrative costs.

  4. Investment Options: Solo 401(k) plans often offer a wider range of investment options compared to SEP IRAs, which may provide more flexibility in building and diversifying your retirement portfolio.

  5. Loan Options: Solo 401(k) plans may allow you to take loans from your account balance, providing flexibility in accessing funds if needed. SEP IRAs do not offer this feature.

  6. Roth Contributions: Solo 401(k) plans may offer a Roth sub-account, allowing for after-tax contributions and tax-free withdrawals in retirement. If you prefer the option to make Roth contributions, a Solo 401(k) might be more suitable.

  7. Business Structure: Your business structure may affect your eligibility to establish certain retirement plans. For example, if you have employees other than yourself and your spouse, a Solo 401(k) may not be feasible, and a SEP IRA might be a better option.

Where do I start?

Choose an institution (Charles Schwab, Vanguard, etc.) and call their customer service to get started. In my opinion, the benefits of a Solo 401(k) seem to outweigh those of the SEP IRA for someone in a solo private practice, so that’s the route I’ll be going.

Questions, comments, etc.?

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