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.

Simplified Employee Pension Individual Retirement Arrangements, or SEP-IRAs allow a sole proprietor to shelter 20% (actually 18.6%, at least until you max out your payroll tax) of your business profit up to $49,000 per year ($50,000 if over 50).  The amount placed into a SEP-IRA is 100% tax-deductible.  You take this deduction on line 28 of the Form 1040.  Whatever amount you put into the SEP-IRA is simply put onto line 28 and becomes an “above the line” (the line is line 38-adjusted gross income) deduction.  A SEP-IRA can easily be set up on line 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 5 minutes.  This simplicity is the main advantage over a solo 401K.

Solo or Individual 401Ks were introduced in 2002.  Rather than limiting contributions to the usual amount of an employee 401K deferral (currently $16,500 per year), 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 $49,000 per year, exactly the same as a SEP-IRA.  A solo 401K, 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 5 minutes.  With that complexity, however, comes a number of options not available in a SEP-IRA.

Advantages of Solo 401K over a SEP-IRA

1) Higher allowable contributions for those making less than $254,460 per year.  It turns out you only need $170,840 in income to max out a Solo 401K, but need more than $80,000 more in income to max out a SEP-IRA.  Here’s a great calculator I found that tells you how much you could put away in each type of plan for your given income.

2) Higher catch-up contributions.  After age 50, you can put $50K per year into a SEP-IRA.  But you can put $54,500 into a Solo 401K.

3) Loans.  You can borrow money from a solo 401K but not a SEP-IRA.  You shouldn’t borrow from either, but at least the option is there in case of catastrophe.

4) Roth Conversion/Back-door Roth IRAs.  SEP-IRAs must be taken into the pro-rata calculation when converting non-deductible IRAs to Roth IRAs.  Solo 401Ks are not subject to that rule.

5) Roth Contributions.  Inside a Solo 401K, your “employee contributions” (up to $16,500) 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.

WCICon18
6) Asset Protection Benefits.  Although most states protect IRAs and 401Ks equally from creditors, at least two (MN and SC) give additional protection to 401Ks over IRAs.

That’s a lot of advantages.  Yet I have used a SEP-IRA several times and have never opened a Solo 401K.  Why is that?  I never actually needed any of these advantages.  If you’re already maxing out an employee 401K at one job (or make more than $254K), don’t need a loan, don’t want to use Roth options (or convert all your SEP-IRA contributions to a Roth IRA), and are under 50, why not choose the simple and easy option?  You can always roll the SEP-IRA over into a solo 401K if you change your mind.