Solo 401(k) Versus SEP IRA: Saving for Retirement While Self Employed
If you’re self-employed, you don’t get the perk of a 401(k) match to help pad your retirement savings. Still, many entrepreneurs prefer the agency of being an independent contractor. When saving for retirement, there are two types of accounts that self-employed individuals usually go for—Solo 401(k) and SEP IRA.
What’s the difference between a Solo 401(k) and a SEP IRA? Is one better than the other when saving for retirement?
What's a Solo 401(k)?
A one-participant 401(k), or Solo 401(k), is a type of 401(k) savings plan suited for a single-member business owner with no employees. It might cover the individual’s spouse if necessary.
Solo 401(k) plans are different from other 401(k) plans because the owner is both the employee and employer. To find out how much you as a self-employed person can contribute to a Solo 401(k) annually, you’ll need to make some calculations.
A Solo 401(k) owner under 50 years old can contribute elective deferrals up to 100 percent of earned income or up to $20,500 in 2022. (For the 2021 tax year, the contribution limit is $19,500.) Anyone aged 50 and over with a Solo 401(k) can contribute elective deferrals up to $27,000 in 2022 (or $26,000 for the 2021 tax year). This includes catch-up contributions for people nearing retirement age.
Owners can also contribute employer non-elective contributions for a maximum of 25 percent of compensation. With these two methods, an individual can contribute no more than $61,000 in total contributions to a Solo 401(k) in 2022 ($58,000 in 2021).
What's a SEP IRA?
A Simplified Employee Pension IRA, or SEP IRA, is a different take on a traditional IRA. Small business owners can make contributions to SEP IRAs on behalf of their employees, but usually self-employed individuals contribute for themselves as their own boss.
For 2022, contribution limits for SEP IRAs are up to 25 percent of compensation (up to $305,000) or $61,000, whichever is less. This is up from $58,000 in 2021.
Is a Solo 401(k) or SEP IRA better? It depends.
For both options, the Solo 401(k) and SEP IRA, contributions can grow tax-deferred until you're ready to withdraw at retirement age. They also both have the perk of offering tax-deductible contributions for business owners.
If you’re a small business owner with a few employees, you can’t get a Solo 401(k), but you can still get a SEP IRA.
If you’re self-employed for part of your work but operate as a W-2 employee for part of the time, a Solo 401(k) might be better. Also, Solo 401(k)s offer the benefits of catch-up contributions for people ages 50 and older. Plus, you might be able to do a Roth-style Solo 401(k) without changing your plan. This means you can pay taxes on contributions now while you’re in a lower tax bracket, assuming you’ll be making more money when you reach retirement age.