Is a SEP-IRA or Solo-401(k) Better?

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Simplified Employee Pension IRAs (SEP-IRAs) are a type of employer sponsored plan. They differ significantly from the standard employer sponsored plans such as 401(k) or 403(b) plans. They also differ significantly from regular contributory individual retirement accounts (IRAs).

For starters, a SEP-IRA only allows the sponsoring employer to contribute. There is no option for employee contributions or deferrals.

Because all contributions are employer contributions, all contributions to a SEP-IRA must be pre-tax Traditional. There is no Roth option.

These employer contributions are subject to the Employer Contribution limit. This limit is applied separately for each employer, although so-called related employers are counted as one employer for the purposes of this rule.

Often times 401(k) plans are laden with record keeping fees, have a limited number of investment choices, and provide poor rebalancing options. SEP-IRAs, on the other hand, can be hosted at any custodian permitted by your employer, do not have limited investment options, and can be traded in per usual.

Like most retirement accounts, SEP-IRAs are subject to Required Minimum Distribution (RMD) rules as well as early withdrawal penalties.

Unlike 401(k) or 403(b) plans which are often not accessible by the account owner until their retirement from that employer or they are over age 59 1/2, the assets in a SEP-IRA are immediately accessible by the account owner. Although early distributions are still subject to IRS tax penalties like other IRAs, you are permitted to perform IRA Rollovers out of your SEP-IRA as you would with other IRAs.

This means the balance of a SEP-IRA can be converted to Roth IRA in the same year your employer contributes to it. This type of Roth conversion is similar to a backdoor Roth strategy, as the SEP contribution deduction and taxable Roth conversion would cancel one another out on your tax return.

This also means you can transfer the balance of your SEP-IRA out to an IRA Rollover if you’d like to use it to perform Qualified Charitable Distributions (QCDs) from its RMDs.

As the IRS says in their guide on establishing a SEP, “You can set up a SEP for a year as late as the due date (including extensions) of your business income tax return for the year you want to establish the plan.” This means that SEP-IRA contributions or even SEP-IRA creation can happen until you file your taxes. That means it could be as late as October 15th of the next year assuming you file for an extension. Before filing, you can then retroactively contribute for the prior year.

In 2022, SEP-IRA contributions are limited to the lesser of $61,000 or 25% of compensation.

Meanwhile, 401(k) plan employer contributions are limited to the lesser of $61,000 or 100% of the participant’s compensation, but the business is only afforded a deduction up to 25% of all participants’ compensation plus the amount of elective deferrals made. In 2022, the employee elective deferrals are limited at $20,500. If the participant is over age 50, they are afforded an additional catch-up contribution of $6,500 which sits on top of the $61,000 employer limit, permitting $67,500 of total savings in a 401(k) for those over age 50.

In this way, you will always be able to save more in a solo-401(k).

Imagine you make $82,000 of adjusted income and are under the age of 50. In a SEP-IRA, you can save 25% for a total of $20,500. In a 401(k), you can save 25% as employer contribution ($20,500) plus the amount of employee elective deferrals ($20,500) for a total of $41,000.

For this reason, most businesses who could benefit from a SEP-IRA benefit from opening a solo-401(k) instead.

That being said, a SEP-IRA can be opened any time before you file your tax return and you can make prior-year contributions at that time. In contrast, a solo-401(k) must be opened and contributed to before the year end to count for that tax year.

In this way, if you have gone a year without a retirement plan and regret that decision, opening a SEP-IRA now for last year before filing your tax return allows you to squeak in some additional retirement savings you would have missed out on otherwise. In all other cases, you can likely save more in a solo-401(k) plan.

Photo by Nathan Dumlao on Unsplash

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Chief Operating Officer, CFP®, APMA®

Megan Russell has worked with Marotta Wealth Management most of her life. She loves to find ways to make the complexities of financial planning accessible to everyone. She is the author of over 800 financial articles and is known for her expertise on tax planning.