When you own a small business, having a plan for your retirement—and your employees’ retirement—is essential. However, not all “standard” retirement plans are built to meet the needs of self-employed people and small business owners. A common question that we receive from small business owners is whether to set up a solo 401k or SEP IRA.
“Solo 401K vs SEP IRA” is a crucial decision for any small business owner. Still, your options may be hard to understand if you’re unfamiliar with the world of retirement planning. Before choosing a retirement fund for your small business, take a look at Janney’s complete guide to these plans’ similarities and differences.
What Is a Solo 401k?
A solo 401k is very similar to a “standard” 401k but created with individual people in mind. As the name suggests, this plan is meant primarily for self-employed folks, so you typically won’t be able to use it if your company has multiple employees. However, you may still be able to rely on one of these plans if your spouse works for you on a full- or part-time basis.
What Is a SEP IRA?
Since SEP IRAs were created in 1978, they have allowed small businesses to enjoy the benefits of individual retirement accounts. Here, SEP stands for “Simplified Employee Pension”—a slight misnomer, as these aren’t defined benefit plans.
Instead, they give self-employed people and small businesses access to tax-advantaged savings accounts that work much like traditional IRAs—as an added perk, these plans come with considerably better tax breaks than standard IRAs.
How Do They Compare?
As of 2023, annual contributions to a solo 401k max out at $66,000. Depending on your age, however, you might be able to put a bit more into your solo 401K than this implies. If you’re at least 50 years old, you can add $7,500 in catch-up contributions to this plan in 2023 for a total of $73,500.
If you’re familiar with a traditional 401k, you probably know these plans allow for contributions from both employees and employers. The same is true for solo 401ks in a way that’s both confusing and helpful. The annual contribution total listed above includes $22,500 in contributions from a self-employed person acting as an employee, along with an additional 25 percent of the same person’s adjusted income which they are allowed to add as an employer contribution.
In contrast, SEP IRAs are a bit simpler but could offer less in the way of savings. Your maximum SEP IRA contribution will be equivalent to either $66,000 or 25 percent of your adjusted net earnings, whichever is smaller. You can expect this to be roughly equivalent to 20 percent of your annual revenue.
SEP IRAs do not allow for contributions from anyone other than employers, so employees are not permitted to make elective contributions to these accounts. Of course, self-employed people can still contribute to SEP IRAs in their capacity as an employer. That also means catch-up contributions for people over 50 are not an option, which is definitely something you should consider if you fall into this age range or are approaching it.
One thing that won’t change between a SEP IRA and solo 401k is the point at which you can withdraw money from your retirement fund. In both cases, you can take money out of your retirement fund without tax penalties after reaching the age of 59 ½.
Which One Is Right for You and Your Employees?
Let’s imagine that you’re a self-employed plumber working on your own. Since you have no other employees, you’d be free to choose between solo 401k vs SEP IRA in this situation. Since solo 401Ks offer higher maximum contributions and potentially larger tax savings, they may seem like the obvious choice. Even so, you’ll need to consider some other factors before making this decision.
While solo 401ks deliver some appealing tax advantages, you’ll need to ask yourself an important question before going for this option: would I like to hire one or more employees in the future? If you’re hoping to expand your plumbing business down the line, you won’t be able to stick with your solo 401k after hiring even one other person to work for you. You’d be required to explore transitioning to a traditional 401k plan or another retirement plan type such as the SEP IRA.
Of course, your retirement plan needs would be completely different if you owned a slightly larger business, such as a local auto shop with a handful of employees. Since you would have someone other than your spouse working for you in this situation, a solo 401k wouldn’t be an option. Instead, you’d want to consider establishing a traditional 401k plan design to help your mechanics save for their retirement.
Chat With Your Financial Advisor
By now, you should have a much better grasp of the differences between SEP IRAs and solo 401ks. While these plans are similar in many ways, they are intended for different types of small business owners. That should make it easier for you to find a plan which is right for you.
If you’d like some help deciding between solo 401k vs SEP IRA, the Laurel Highlands Wealth Advisory Group at Janney is here for you. To start working with Janney, all you need to do is reach out. Let’s find a time to chat about retirement plans and any other financial concerns you have!
