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.
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!