I’ll admit. This retirement stuff can be confusing. I mean really confusing.
401K’s, IRA’s, wait…there are more than one kind of IRA? SEP IRA? ROTH IRA? ROTH 401K?? What are they trying to do to you!?! How do they compare? Why are there so many plans!? Is there really a difference in a Solo 401(k) or a SEP IRA?
To keep the confusion to a minimum, let’s look at two available options and how they would fit into your retirement plans.
Let’s compare a Solo 401(k) or SEP IRA.
Let’s lay the foundation. We’ll be looking at Tom & Steph. Steph is an orthopedic surgeon and Tom manages Steph’s medical practice. They have no employees currently but that could change. Steph does well and brings in around $600k per year. They have very little in the way of overhead expenses. Let’s say 10% of receipts.
I’ll also be comparing the Solo 401(k) or SEP IRA plans with the business in a corporation, and as a sole proprietor.
I. Solo 401(k)
This plan is a combination of a 401(K) plan and a SEP IRA. The first part is a 401k, similar to what you may participate in working at a larger company. 2023 401k contributions are limited to $22.5k with a catch-up provision of $7,500 for those over 50. The company can then match up to 25% of W2 wages as a SEP Contribution. With the catch-up contribution, you are limited to $73.5k in total contributions.
- A. Eligibility and contribution limits: Solo 401(k) plans are often referred to as a Married 401k since you must be self-employed with no full-time employees other than your spouse. Limits for the Solo 401(k) are higher than other retirement plans due to the dual nature of the plan types. For 2023, the maximum contribution limit is $62,500 ($73,500 if you’re age 50 or older).
- B. Employee and employer contributions: One of the advantages of a Solo 401(k) is that it allows both employee and employer contributions. As an employee, you can contribute up to $22,500 ($26,000 if age 50 or older) in 2023. Additionally, you can make employer contributions of up to 25% of your net self-employment income.
- C. Tax advantages: Contributions through payroll and profit sharing (SEP) reduce taxable income in the corporation. With a maximum tax rate of 21%, you can expect to save at least 21% on your contributions.
- If you are a Sole Proprietor, contributions are deductible against all income but the calculation is based on net self employment income. Since the max tax rate for an individual is 37%, you could conceivably save up to 37% on your contributions.
- D. 401K and borrowing against your balance: As with regular 401k plans, you can “borrow” from your balance. You must pay this back just like you would if you borrowed from a bank. Most of my exposure to people borrowing against their 401k were taxpayer borrowing the funds as a down payment on a new home.
- E. Sole Prop vs Corp: Here’s where they differ the most. If the business is in a corporation as shareholders you must be on payroll. The contribution is determined by how much you were paid through payroll. Since many S Corp owners also take distributions (which are not part of the calculation), the amount you can contribute may affect total payroll taxes.
If your business is a Sole Proprietorship, the calculation is based on your net income. This may allow you to contribute more vs. a corporation, but you won’t get the employment tax savings if contributed via payroll.
Now let’s take a look at the SEP IRA part of our 401(k) vs SEP IRA comparison
II. SEP IRA
This is the “not 401k” part of a Solo 401k plan with different limits. A Simplified Employee Pension Individual Retirement Arrangement (SEP IRA) is another retirement savings option generally for self-employed individuals. The total contribution limits are the same as a Solo 401k.
- A. Eligibility and contribution limits: The biggest difference between the two plans is the ability to have employees other than your spouse on payroll. The contribution calculation as a sole proprietor is 20% od net self employment income.
The biggest difference is calculating as an employee of your own corp. The calculation is still 25% of your W2 wages. To contribute the max SEP in a corp, you must have $264k of wages. Compared to a Solo 401k,, your W2 wages need to be $174k (after the Solo 401k employee contribution) for a total of $204k in wages. - B. Employer contributions: A SEP IRA is a fully employer based contribution. There are no catch-up provisions with a SEP so the max contribution allowed is $7,500 less (the catch-up provision allowed with e 401k contribution).
- C. Tax advantages: Contributions made to a SEP IRA are tax-deductible for the employer. For the employee, the contributions grow tax-deferred until retirement, similar to the Solo 401(k). Tax savings as a percentage are the same as for a Solo 401k. Possible savings are lower due to the lower contributions allowed.
- D. You can’t borrow against your SEP IRA balance. Keep this in mind when choosing your plan. The ability to borrow against your retirement funds is a nice feature to have in your back pocket.
- E. Sole Prop vs. Corp: Due to the disparate difference in tax rates, you would most likely save more as a Sole Proprietor (37% max vs 21% max).
III. Now Let’s Compare the Two: When should you use a Solo 401(k) vs a SEP IRA?
| Solo 401k | SEP IRA | |
| Eligibility and contributions | Can only be used for Sole Proprietors with no employees other than a spouse. Solo 401k’s are expressly forbidden if you have employee’s other than a spouse. | SEP IRA’s are available to any business with or without employees. |
| Employee and Employer Contributions | Solo 401k’s are a combination of a 401k and a SEP IRA. The employer contribution component is still the SEP. There is no employer match of the 401k contribution. | SEP IRA’s have no povision for employee contributions. 100% of the SEP contribution will come from the employer. If you have employees, they must be allowed to participate if they qualify. |
| Tax Advantages | All contributions are deductible as an expense directly on your corporate return. Contributions are also deductions on your individual return, except it doesn’t reduce Self Employment income so it doesn’t affect your individual self employment tax. Contributions made by the employee is a reduction of taxable income on their return as well. | All contributions are deductible as an expense directly on your corporate return. Contributions are also deductions on your individual return, except it doesn’t reduce Self Employment income so it doesn’t affect your individual self employment tax. Since there are no employee contributions, SEP contributions do not affect the employees taxes. |
| Borrowing? | You can borrow against the balance in your 401k. Generally you have 5 years to pay the loan off unless you are buying your principal residence. If borrowing to by a home, you have upwards of 25 years to pay the loan back. | You cannot borrow against your SEP IRA account. |
| Sole Prop vs Corp | The method of calculating your contribution as a corp is dependent on wages paid on your W2. Calculating your contribution as a Sole Proprietor uses the Net Self Employment figure, but does not reduce self employment tax. | The method of calculating your contribution as a corp is dependent on wages paid on your W2. Calculating your contribution as a Sole Proprietor uses the Net Self Employment figure, but does not reduce self employment tax. Since there is no employee contribution the employee doesn’t get any tax relief. |
IV. Now that you have all this great info in your head, which one is right? Solo 401(k) or SEP IRA
- A. Employees?: If you don’t have employees and are married, the Solo 401(k) is probably the better choice. However, if you have employees or anticipate hiring in the future, the SEP IRA allows you to make contributions for yourself and your employees.
But. There is no reason you can’t start with the plan that best serves your needs at that moment and move to a different plan at a later time that suits your needs better at that time. - B. Contributions?: A Solo 401k has higher contribution limits, so if that’s your goal a Solo 401k plan is the one for you. I also believe there is no other plan better suited for a married couple working on their business.
A SEP is a lot easier to fund, but you have a lower contribution limit and if you have employees, they must be included and receive a share of any contribution. - C. Loans and Accessibility: Being able to borrow against the balance in your 401k can be a life saver. With no ability to access funds, other than through a distribution you will likely pay a penalty on, as well as tax, a SEP gets a big thumbs down here.
V. Conclusion: Solo 401(k) vs. SEP IRA Final Say!
With the level of complexity associated with most retirement plans it’s no wonder people panic and are anxious when having to make a decision as big as “What Plan Is Best?”.
They look at their current situation, and also envision how the company will look in1, 2, 5 or 10 years. With the invariable “Will this plan work for me in 10 years?” questions on the fringe of your thinking.
So what to do?
Husband or Husband/Wife teams would almost always benefit from utilizing a Solo 401k plan. With the ability to sock away $73,500 each in 2023 (and the max contribution amount goes up almost every year), a Solo 401k plan can be a great conduit to saving for retirement.
If you have employees, the best of the best is a SEP plan. You can contribute the most of any of the other plans (minus the above Solo 401k plan and a Defined Benefi plan, which we will discuss later). The big negative for most small businesses would be the requirement to fund your employees accounts as well as yours.
If circumstances change, like the wife has a baby and they decide the husband will stay home and raise the kids, you can change plans.
Watch for future comparisons between the most popular plans. I’ll be comparing between the following plans:
Traditional IRA
ROTH IRA
Defined Benefit Plans
Defines Contribution Plans
SIMPLE IRA Plans
ROTH 401k Plans
Until next time, thanks for reading and stay cool!
JKC