Helping sole proprietors choose between a solo 401(k) and a SEP-IRA (2024)

The simplified employee plan–individual retirement account (SEP-IRA) has long been the star option for sole proprietors seeking to reduce income taxes and save for retirement beyond the lower contribution limits of traditional individual retirement arrangements (IRAs). However, with discount brokerage firms' improvements in ease of account establishment and management, the IRS-termed one-participant 401(k) plan, often referred to as the solo 401(k), is growing in popularity.

On the surface, the solo 401(k) may appear to be unquestionably the preferable option due to having a higher potential contribution amount, along with the low fees and vast suite of investment options that SEP-IRAs have always enjoyed. In addition to the employer contribution, which is calculated in the same manner as the SEP-IRA contribution maximum, 401(k) holders may also elect up to the annual employee deferral limit, which is $23,000 ($30,500 for age 50+) for tax year 2024, so long as their business generated enough net profit.

However, several nuances make this a more complicated choice for clients beyond just asking them if they want to maximize tax-favored savings limits.

This article offers a high-level overview of some of the most common considerations when choosing between the SEP-IRA and the solo 401(k) but does not cover every aspect of the differences between the two accounts. For a deeper dive into the solo 401(k) and all of the nuances to consider, a suggested book is Solo 401(k): The Solopreneur's Retirement Account by Sean Mullaney, CPA.

Contribution limits

The most notable difference between the SEP-IRA and the solo 401(k) is that, as discussed below, the 401(k) allows sole proprietors to contribute more, up to $69,000 in 2024 ($76,500 for age 50+) if there is enough compensation to support it, without having to have the full $345,000 in net profit for the year that would be required to contribute the same amount to a SEP-IRA.

SEP-IRA holders are limited to contributing 25% of earned income. Earned income is calculated by taking the net profit of the business and deducting both one-half of the self-employment tax assessed on it as well as any tax-deductible contributions made to the SEP-IRA for the account holder.

In comparison, solo 401(k)s generally allow higher contributions because there is both an employer and an employee contribution, and the latter is not subject to the 25% restriction. The difference is illustrated below.

SEP-IRA contribution max calculation:

For example, Corey, a Schedule C sole proprietor who is age 38 and has a $150,000 net profit, can contribute a maximum of $27,881 to her SEP-IRA, assuming she wishes to deduct her contributions from her business profit. To arrive at that number, first she must calculate the plan's reduced contribution rate based on her desire to deduct and contribute the full 25% allowed to her SEP-IRA as follows:

Next, we note the fact that she must pay $21,194 in self-employment taxes and use that to calculate her own contribution and deduction for that contribution, again assuming she elects pretax contributions.

See Also

What Is a SEP IRA and How Does It Work?

For example, access to funds within a SEP-IRA follows rules similar to those governing all other IRAs — there are early-withdrawal penalties, with exceptions — and SEP-IRA assets are subject to account aggregation rules when figuring nondeductible Roth conversions and required minimum distributions. In contrast, solo 401(k)s are governed by the same rules as larger workplace retirement plans, which may be important to clients in certain circ*mstances.

Account aggregation for backdoor Roth purposes

For clients wishing to fund a Roth IRA using the "backdoor" strategy, assets in a 401(k) are not subject to account aggregation rules, while SEP-IRA assets are. This is an advantage of solo 401(k)s because the inapplicability of the aggregation rules allows for tax-free Roth conversions of nondeducted IRA contributions, assuming no other IRA assets exist for the client. (For more on the backdoor Roth strategy, see "How the Mega-Backdoor Roth Works," JofA, May 9, 2023.) Additionally, if a client does have existing IRA assets, including a SEP-IRA, they can roll those funds into a solo 401(k) to enable tax-free backdoor Roth IRA contributions.

Ability to borrow from 401(k) funds

Another desirable feature of solo 401(k)s is the ability to borrow from plan assets. Generally, an account holder can borrow up to the lesser of 50% of their plan balance or $50,000 from an active 401(k) plan, then pay those funds back with interest, which goes toward the account balance (and not to a bank or other financial institution).

The SEP-IRA does allow a taxpayer to take a distribution from the IRA and treat it as a short-term loan. However, this can be risky, because under the 60-day indirect rollover rule, the distribution will be a taxable distribution to the taxpayer if, for whatever reason, they do not redeposit the full amount distributed within 60 days. In addition, a taxpayer may make only one rollover from an IRA to another (or the same) IRA in any 12-month period, regardless of the number of IRAs the taxpayer owns.

When it comes to borrowing from a 401(k), the client will need to decide if they wish to enable this feature when establishing their solo 401(k). While borrowing against one's retirement funds is generally not a best practice for long-term wealth building, the ability to leverage those funds may help an entrepreneur expand their business or refinance debt.

Access to funds for other purposes

While solo 401(k)s allow borrowing from plan assets, it should be mentioned that they do have stricter rules surrounding early withdrawals that do not apply to SEP-IRAs. The list of exceptions allowing for what's called "hardship withdrawals" is specific for 401(k)s by statute, while IRA funds can, for practical purposes, be withdrawn for any purpose, although there are typically tax penalties and consequences to contend with.

While no business owner starts a retirement savings plan with the intention of accessing the funds for other purposes, it's important for clients to know that choosing a solo 401(k) is a stricter commitment to that purpose than a SEP-IRA in cases of severe hardships.

Timing of contributions, particularly for S corporation owners

A potential disadvantage of solo 401(k)s has to do with the timing of first-year contributions. While both SEP-IRAs and solo 401(k)s allow for the employer contribution to be made up until the tax filing deadline of the business (March 15 for S corporations, unless extended; April 15 for Schedule C, unless extended), the employee contribution amounts in a solo 401(k) must be made from compensation, which, particularly in the first year the plan is established, adds a layer of planning for S corporation owners, as the contributions must be made from payroll.

If an S corporation owner waits until later in the tax year to start their solo 401(k), they may not be able to make the maximum employee contribution amount ($23,000 in 2024) for the first tax year due to a lack of available payroll runway left in the year.

Schedule C sole proprietors do not have this concern, as SECURE 2.0 Section 317 allows sole proprietors to retroactively elect employee deferrals in the first year of a solo 401(k) plan's establishment. Future years' employee deferrals can be made in a lump sum at the end of the calendar year.

Account establishment and tax reporting

One commonly cited drawback of solo 401(k) plans that does not exist with SEP-IRAs is that 401(k) plans have slightly more complicated account applications. While the discount brokerage network has simplified the process, business owners are still required to make several administrative decisions to establish a plan, and, in some cases, those documents must be physically signed and mailed before the plan is open for contributions.

In addition, solo 401(k) plans with more than $250,000 in plan assets are required to file Form 5500-EZ, Annual Return of a One-Participant (Owners/Partners and Their Spouses) Retirement Plan or a Foreign Plan, which is a relatively simple form, but worth mentioning as an added complication.

SEP-IRAs, on the other hand, can often be opened and funded online in the same day, with little tax or retirement plan knowledge needed to avoid potential mistakes. There is also no additional tax filing needed for SEP-IRAs on behalf of the business.

Clients establishing solo 401(k)s may need a little more handholding, which can be a burden to CPAs who are not proficient in the nuances of the rules for retirement savings plans.

Final thoughts

If a sole proprietor anticipates hiring a full-time employee, especially sooner rather than later, this may affect the choice of plan, as the rules for contributing when you have employees vary based on plan type.

Understanding the above differences between solo 401(k)s and SEP-IRAs can go a long way in helping clients to make the best decision for their bigger-picture tax and retirement savings goals.

For more on this topic, listen to the AICPA PFP Section podcast "Building Business Owner Wealth With Tax Advantaged Plans." PFP Section members can also consult The Adviser's Guide to Financial & Estate Planning, Vol. 2.

— Kelley C. Long, CPA/PFS, CFP, is a personal financial coach and consultant in Arizona. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld at [email protected].