By Dr. James M. Dahle, WCI Founder
If you work as an independent contractor, meaning you get a Form 1099 each pay period instead of a W-2, you're responsible for your own benefits, including a retirement plan. Your two main choices are a SEP-IRA or a solo 401(k) also known as an individual 401(k). This post will help you decide which to use.
What Is a SEP-IRA?
Simplified Employee Pension Individual Retirement Arrangements, or SEP-IRAs, are a good fit for a small business owner with few to no employees or the self-employed. A sole proprietor under 50 can shelter 20% of net business profit, up to a total contribution of $66,000 for 2023. If you have employees, you'll have to contribute an equal percentage of income into their account as you did into your own.
The amount placed into a SEP-IRA is 100% tax-deductible. You take this deduction on line 15 of Form 1040 Schedule 1. Whatever amount you put into the SEP-IRA becomes an “above the line” (the line is line 11 of Form 1040, also known as “Adjusted Gross Income” or AGI) deduction.
A SEP-IRA can easily be set up online with most major brokerage companies, such as Vanguard, and funded with a simple electronic funds transfer from your personal or business account. It took me less than five minutes. This simplicity is a significant advantage over a solo 401(k).
Another advantage of a SEP-IRA is that the account can not only be funded after the end of the year, but it can be opened after the end of the year. You just have to open and fund the account before your tax date, usually April 15, but can be as late as October 15 with extensions. There is no such thing as a “Roth SEP-IRA,” but you can roll over a SEP-IRA into a Roth IRA each year as a Roth conversion.
What Is a Solo 401(k)?
Solo 401(k)s were introduced in 2002, and they are a good fit for the self-employed/business owners who employ their spouses but have no employees. Both the owner and the employed spouse must receive the same percentage of contribution.
Rather than limiting contributions to the usual amount of an employee 401(k) deferral ($22,500 per year for both 2023), the laws allow you to also put in an employer contribution (really all the same money for a sole proprietor), for a total of up to $66,000 per year in 2022, exactly the same total contribution as a SEP-IRA. If 50+, you also get an extra $6,500 as an employee catch-up contribution.
A solo 401(k), however, is a more complex beast than a SEP-IRA. You are required to have a plan document, for instance. This isn't a big deal, and the paperwork at most brokerage options walks you through it quickly, but it will take longer than five minutes. It is not unusual for it to take a few weeks to get it all set up. With that complexity, however, come a number of options not available in a SEP-IRA.
401(k)s need to be opened by the end of the calendar year and the employee contributions should also be funded by the end of the year. You do have until tax day to fund the employer contributions, however. Once there is over $250,000 in it, you'll need to file Form 5500-EZ each year too.
If you are interested in “self-directed” retirement accounts (used to invest in non-traditional assets like precious metals, cryptocurrencies, real estate, etc.), both SEP-IRAs and solo 401(k)s can be used.
7 Advantages of a Solo 401(k) vs SEP-IRA
There are at least seven ways solo 401(k)s are better than SEP-IRAs.
#1 Higher Allowable Contributions for Many Earners
As a sole proprietor, you only needed $192,500 in income to max out a solo 401(k) in 2021, but you needed $290,000 to max out a SEP-IRA. This is because the employee contribution less of the $58,000 contribution [in 2021] had to come from the “employer contribution,” where it is limited to 20% of net self-employment income. This income is net of all business expenses, including the employer half of the payroll taxes.
Here's a SEP-IRA calculator to figure out the annual contributions permitted. Sometimes this 20% number is phrased as 25% of wages, but for a sole proprietor, this is really the same number. It's 20% if you include the retirement plan contribution, 25% if you do not include the contribution itself. Note that if you are an S Corp (or an LLC filing as an S Corp) you are limited to 25% of actual wages paid. Even if the business made $300,000, if you only paid yourself $100,000 as salary, your employer contribution will be limited to $25,000.
#2 Loans
You can potentially borrow money from a solo 401(k) but not a SEP-IRA. You probably shouldn't borrow from either, but at least the option is there in case of catastrophe. You can generally borrow up to $50,000 per year, or 50% of the balance, whichever is less.
#3 Backdoor Roth IRAs
SEP-IRAs must be taken into the pro-rata calculation when converting non-deductible IRAs to Roth IRAs, but, thanks to the Secure Act 2.0, that requirement will be dropped in 2024. Solo 401(k)s are not subject to that rule. As a result, most SEP-IRA users couldn't do a Backdoor Roth IRA and missed out on this great opportunity. Learn more with our Backdoor Roth IRA Tutorial.
#4 Roth Contributions
Inside a solo 401(k), your “employee contributions” (up to $22,500) can be designated as Roth contributions. This not only allows you some tax diversification benefits, but also allows you to save more money in a tax-protected manner since after-tax money is worth more than pre-tax money.
#5 Mega Backdoor Roth IRA Contributions
Although SEP-IRA contributions can be converted into a Roth IRA each year, only a 401(k) allows a true Mega Backdoor Roth IRA contribution. These are after-tax contributions with either in-plan Roth conversions or in-service withdrawals with a conversion to a Roth IRA. These allow investors to put the entire $66,000 contribution into a Roth account. This can be very beneficial when trying to maximize the 199A deduction.
#6 Asset Protection Benefits
Although many states protect IRAs and solo 401(k)s equally from creditors, at least two (Minnesota and South Carolina) give additional asset protection to solo 401(k)s over IRAs.
#7 Catch-Up Contributions
Starting at age 50, an employee can contribute an extra $6,500 into a 401(k) as an employee contribution. This cannot be done in a SEP-IRA.
That's a lot of advantages. I have used both types of accounts to good advantage at various times in my investing career. However, my general recommendation for an independent contractor is to use a solo 401(k) for the reasons outlined above.
However, if you don't care about any of those advantages or just need the ability to open it after the year is over, take a careful look at a SEP-IRA. You can always roll it into a solo 401(k) (well, except at Vanguard) later.
If you have employees, choosing a retirement plan is no longer a do-it-yourself project. You should seek out professional help to study your business, understand what you want out of a retirement plan, and understand what your employees are likely to do if offered a retirement plan. The right plan for your business may be a 401(k), a SEP-IRA, a SIMPLE IRA, or no plan at all.
What do you think? Do you use a SEP-IRA or a Solo 401(k) and why? Comment below!
Good stuff.
But what about cost? Solo 401ks are more expensive, aren’t they?
Qualified plans, individual 401k’s do have a plan fee of typically around 100 to 150 and that’s annual. They also have partisans acct fees per auction of typically in the 60 range annually.
I don’t think Vanguard or Fidelity charge a fee for their cookie-cutter individual 401(k) plans.
E*TRADE also has no fee for their cookie-cutter individual 401(k) plans.
Or Fidelity or Schwab.
another option is to create a defined benefit plan. Depending on your age, you can contribute a lot more per year. Im now 41 and can contribute about 70k and can also have an associated 401k/PS with it that i can contribute another 31k towards. The big problems with the defined benefit plan is that yearly funding is mandated (it isnt flexible) and it costs much more to have. Schwab seems to have a good low cost situation for starting one. Whatever you do, however, avoid the 412i and 412e, defined benefit plans. Google 412e white paper to figure out why its a bad idea.
Solo 401K at Vanguard doesn’t cost anything more than a SEP-IRA, which is basically nothing aside from the ERs of the funds.
@ Rex- A defined benefit plan can be held in addition to a 401K. For example, the defined benefit plan in my group allows $31K in addition to the $49K that I can put into the 401K. I wouldn’t hold a DBP instead of a solo 401K or SEP-IRA. There are additional costs and flexibility issues associated with it.
yes that is correct and what i was trying to say in my post that you can have both as well. if you have a defined benefit plan, you typically should be able to contribute more than 31k per year but that then effects the total you can contribute to your 401k piece. In your situation, you have sort of done the opposite of what most do which is max out the DB and then you would only be able to put 31k into your defined contribution or 401k piece. The reason to do it that way is bc you can then ensure you have put away enough to get the defined benefit amount while the 401k piece may be greater or less depending on returns. The negatives of that approach are the decreased flexibility you mentioned. Since you are paying for both, its really up to you which way to handle it especially if you are a 1099 person.
Not sure I follow you exactly. Defined benefit plans come in a lot of flavors. Ours is limited (in fact it’ll probably go down to $15K next year instead of $31 due to top-heavy rule issues) due to the structure of the business and number of participants. Ours is actually invested in a reasonable mix of mutual funds (60/40) and so it is dependent on performance as well. Since you can roll it out into an IRA as soon as you separate from the company, it’s really just some additional 401K space where you don’t get to choose how it is invested.
They do come in a few flavors but your article is targeted towards 1099 folks. In this situation, you can greatly control the investments. As a 1099 person, the issue then becomes are the costs of having such a plan worth it. In my opinion, the best way for a 1099 would be sep until mid 50s when hopefully kids out of college and at that point change to db plan with a 401k. The deductions would be high and greatly increase your tax deferred space. At that point the costs likely aren’t as bug a deal.
If you are employed by a nonprofit hospital system, can you take advantage of any additional tax savings or SEP if you already have a 401K with the employer? Any good books that would help an employed physician save on taxes? Thanks
No, you cannot do a SEP or a solo 401K unless you have a separate moonlighting independent contractor (1099) job.
You could do backdoor Roths and maybe an HSA though.
I don’t know of a tax book specific to an employed physician. You might browse through my bookstore though and see if something there seems to fit. Maybe taxes for dummies. Or perhaps an investing book such as the Bogleheads Guide that would discuss various tax-protected and tax-efficient ways of investing.
Just to clarify – if your main income is generated via W2 but you have moonlighting income through 1099, can you have two 401ks? Assuming the answer is yes – the 401K through the main job will have a max of 18K but does that affect the max contribution of the solo 401K that you set up with income from the 1099 moonlighting job or are they completely independent?
Yes.
The main job is determined by their rules. The individual 401(k) has a limit of $54K if you have enough income.
One $18K employee limit between the two of them.
One $54K total (employee, employer, match) limit for each of them.
Thanks for the super quick reply!
I see. so if I were maxing out my (unmatched) 401K at my main W2 job, I would get to put in 18K but that means that I can’t put in another 18k in a solo 401k, but rather only the 25% of the 1099 income, correct?
Let’s say I had 350K income in W2 and 18K goes into 401k. And let’s say an additional 50K in 1099 income. This would mean I can contribute a total of 30.5K in pretax dollars into 401ks, right? (18K into the normal 401k and 12.5K into the solo 401K)
And does any of this depend on if I am just filing normal 1099 versus forming an S corp?
Right. Except it works out to be about 20%, not 25% of your $50K. So $28K.
I don’t think I’d bother with an S Corp, but if you do, I believe you can do a full 25% of what you pay yourself as salary.
What if the issue is your too late setting up solo 401k. You didn’t know for sure if you were going to get 1099 (got paid for working in rural area). Would like the sep ira to lower tax. However previously did the backdoor conversion. Also put money in main employer 401k. Thanks
I have a question about the terminology of these accounts. I will be setting up one of these accounts this year for my 1099 income. I have been looking through the tax documents and they mention the SEP, SIMPLE IRA, and SIMPLE 401k. I do not see anything about the Solo 401k as being tax deductible. On Vanguard I see the Individual 401k, SEP-IRA, and SIMPLE IRA listed. Is the Solo (Individual) 401k the SIMPLE 401k?
Thank you.
No. The solo 401K is the individual 401K. A SIMPLE is different and not desirable for a sole practitioner without employees.
Thanks for the quick reply. I’m just confused on the tax deductions for the two different accounts. On the IRS pub 560, they list the SEP and SIMPLE accounts as qualified tax deductible accounts for self-employed income, which goes into line 28, but there is no information in the document about the solo 401k. Does the solo 401k also get included in that line? Or am I wrong in thinking that it would be a tax deductible account?
In Pub 560, 401Ks are called qualified plans (section 4.) I’m not sure exactly how it gets entered on the 1040. I think it is deducted out as a business expense because with my regular old 401K, that money isn’t included on my W-2 box 1. So I don’t think you have to take it back out on line 28 like a SEP-IRA.
I think that’s right. I think you deduct it on line 19 of schedule C. Oh never mind. The instructions for Schedule C say put it on line 28 if you’re the only employee.
Ah great. Thanks for the help. I kept reading that document as SIMPLE 401k being what they refer to as a 401k, but I now see that they mean that when they refer to it directly. So both plans are handled in the same way with taxes – tax the amount on the self-employment tax but the adjusted gross income decreases by that amount. I wanted to make sure I didn’t miss out on an additional break on the self-employment taxes if I went with one over the other.
In the first paragraph of :
Sep-IRA vs Solo 401K
If you work as an independent contractor, meaning you get a Form 1099 each pay period instead of a W-2, you’re responsible for your own benefits, including a retirement plan. Your two main choices are a SEP-IRA or a Solo 401K. This post will help you decide which to use.
What if you are not an “independent contractor” but a “non-independent contractor” and the firm that pays me does not offer any pension or 401k plan can i still get a SEP-IRA or solo 401(k)?
What is a non-independent contractor? It sounds like an employee. I don’t believe there is an IRS category called “non-independent contractor.” If you have no retirement plan and are an employee, you are NOT eligible for a solo 401K or a SEP-IRA. You can do an IRA or Roth IRA (if eligible) or a backdoor Roth IRA if you make a typical physician income.
If you’re not sure if you’re an employee or an IC, take a look at what they send you at tax-time. If it’s a 1099, you’re an IC. If it’s a W-2, you’re an employee.
I have a full time job as an employee and moonlight a second job as an independent contractor.
I max out my elective deferral every year and my full time employer also adds profit sharing contributions up to the 49k maximum.
Can I still contribute 20% of my 1099 income to a solo 401k, or are you not allowed to exceed 49k in tax deferrals in all accounts combined?
Yes. You can also do personal and spousal backdoor Roth IRAs, perhaps an HSA, and if your employer allows, a cash balance or pension plan. There are also worse things than investing in a taxable account.
[Answer updated 2020]
What would you say the minimum allocation needs to be in order to make a personal pension plan worthwhile? Is a personal pension plan the same thing as a defined benefit plan?
I dunno, but certainly at least a 5 figure amount each year.
Yes, same thing.
I just read your post on the rules for having more than one 401(k) here: https://www.whitecoatinvestor.com/multiple-401k-rules/
Since Kevin’s moonlighting and his W-2 job are not considered to be in the same controlled group, I was wondering why he wouldn’t be eligible to make employer contributions to a Solo 401(k)?
Thanks!
Great catch. I clearly gave bad advice. I should have read that post I wrote in 2015 before writing this one in 2011. 🙂
I am separating from the Military and looking at joining a small group practice (3-4 providers). This job offer is for an employed position (W-2 employee), but they do not offer any health insurance or an employer sponsored retirement plan. The compensation would be a percentage of collections with a guaranteed base for the first year. However, I really like the idea of being able to invest in a solo 401K or a SEP-IRA. Should I negotiate the compensation to be a higher percentage of collections in return for working as an independent contractor (1099) so I can set up my own retirement investment vehicle? I believe that negotiating an increase in the percentage of collections that they pay me to be around 7.65% higher than the current offer (the employer normally pay half of the social sec and medicare tax. I believe half is 7.65%) would be appropriate. What do you think?
If you are an independent contractor you will have to pay for a medical malpractice insurance policy, possible errors and omissions policy, general liability, etc. you are most definitely not covered by their group malpractice policy if you are an independent contractor.
IRS have rules about being an independent contractor. The employer can’t tell you when to work, how to work, etc.
Sometimes being an independent contractor sounds better but you make less money when you factor everything else in.
I spent part of my career as an independent contractor.
Isn’t funding a “Backdoor Roth IRA” at $5000 per year part of an optimal retirement investing strategy? The tax advantages for withdrawing from a Roth versus other account types seem huge, especially if passed on to future generations.
I feel like yearly Roth’s should be given a high priority in a retirement investing strategy. If this is the case, then 401k is clearly the way to go since (because of pro-rata rule) having a SEP-IRA costs you an approximately $1500 extra in taxes per year to convert a $5000 Traditional IRA to a Roth IRA.
Am I way off the mark here in my love of Roth IRA’s? Does the loss of tax-deferment (ie you cannot deduct contributions made to the Traditional IRA used to create the Backdoor Roth IRA) offset the benefits of ultimately having NO taxes on the back-end from a Roth?
In your peak earning years you should still favor a deferred tax approach, but you’re right that it is ideal to at least have some Roth accounts. I use a traditional 401K and Roth IRAs. But it’s reasonable to do the employee contribution as Roth and the employer match as traditional or any other combination you choose. But going all Roth in your peak earning years is a mistake IMHO.
You’re right that a Solo 401K is much preferable to a SEP-IRA for someone looking to save a lot of money.
What about the following? I am the only employee of my own PC which is an S corporation. I receive a paycheck through the PC and a W-2. There is another separate PC that has physician employees and office staff. Can I use a SEP or Solo 401k. Do I have to make contributions for the employees if they are not paid through my own PC?
Solo 401k Contributions have multiple components, among those are the (a) employee-deferral and (b) employer profit-share. The employee-deferral limit is annual “unified” per-employee limit covering all plans in which an individual participates; i.e., you can’t double-up on employee-deferral contributions by participating in multiple plans. In contrast, the employer profit-share limits are “per-plan” and you can, therefore, double-up on those.
However, key tax and retirement plan concepts to be aware of are “controlled group rules” and “affiliated services group rules.” These rules require the aggregation of plans sponsored by related businesses – under certain circumstances. A Solo 401k Plan can offer incredible tax and investment flexibility, but it must be a Solo 401K Plan. A plan that is required to be aggregated with other plans sponsored by businesses which have full-time employees would not qualify as a Solo plan. In your scenario, implementation of a Solo 401k should be analyzed within the context of the “controlled group rules” and “affiliated services group rules.”
Info and many tax code citations regarding controlled group rules: https://www.401kcheckbook.com/solo-k-eligibility-parents-children-related-perspective-irs/
Interesting question. I’m not sure I know the answer. The answer may even be state-specific. I suspect you cannot use a SEP-IRA or a Solo 401K with your structure, but I could definitely be wrong. I would pay both an accountant and an attorney in my state for advice on this before starting a Solo 401K. It’ll be money well spent.
How come you set up your structure this way? If this structure (two PCs) does allow you to start your own retirement plan and not have to provide one for your employees I’m sure there would be a lot of people interested in adopting it. I suppose it might even allow you to have your own benefits package. What is the relationship between the two PCs?
this was set up so that each individual could act independently, from a financial perspective, except for common office expenses that were shared, i.e. overhead, employee salaries, etc. those funds then go through the group PC. As far as the relationship between the two, other than the fact they are owned by the same individuals, I dont think they are related. But I wonder if that might be enough to prevent me from setting up a plan for myself.
Unfortunately I’m not sure. Please do let me know what your attorney/accountant says about it.
A tip for those who get both W2 and 1099 (resident who moonlights):
– Deducting 1099 income saves you more taxes vs. W2 income. So if you can, open the solo 401k and put the 1099 income into it, and contribute less from your W2 at work.
I was playing with the TaxAct calculator and realized this. I’m sure it has to do with self-employment taxes having to cover both employer and employee parts of the Medicare tax.