By Dr. Jim 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), aka an individual 401(k). This post will help you decide which to use. If you want the TLDR version, the right answer for you is probably a solo 401(k).

But let's explore the issue further.


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 and $69,000 for 2024. If you have employees, you'll have to contribute an equal percentage of income into their accounts 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, aka “Adjusted Gross Income” or AGI) deduction.


Advantages of a SEP-IRA

While a SEP-IRA is usually the wrong choice for most independent contractor doctors, it does have some advantages over a solo 401(k).

  1. 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 when I opened one many years ago. (Note that I switched to a solo 401(k) later.) This simplicity is a significant advantage over a solo 401(k).
  2. Another advantage of a SEP-IRA is that the account can be funded after the end of the year AND it can be opened after the end of the year. However, this advantage was lessened by the Secure Act 2.0 legislation, which basically allows the same thing even for the employee contribution of a solo 401(k).  You just have to open and fund the account before your tax date—usually April 15, but it can be as late as October 15 with extensions.
  3. Starting in 2023 and as a result of the Secure Act 2.0, there is now the possibility (if your SEP-IRA provider allows it) of Roth contributions into a SEP-IRA.
  4. You can roll over a SEP-IRA into a Roth IRA each year as a Roth conversion, too. There is no two-year waiting period like with a SIMPLE IRA or a SIMPLE 401(k). Most solo 401(k)s don't allow in-service rollovers out of the plan.
  5. Unlike a solo 401(k), you are not required to file IRS Form 5500-EZ each summer for a SEP-IRA, even once the account has more than $250,000 in it. While this form is not hard to fill out, the penalties for not doing so are massive.

More information here:

Best Retirement Savings Plans for the Self-Employed


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—even those who employ their spouses if there are no other employees that would qualify for the 401(k). 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 in 2023; $23,000 in 2024), 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 2023 ($69,000 in 2024), exactly the same total contribution as a SEP-IRA. If 50+, you also get an extra $7,000 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, comes a number of options not available in a SEP-IRA.

Once there is more than $250,000 in it, you'll need to file Form 5500-EZ each year too. Do not forget this. It's due July 31 each year starting the year after it finishes the year with $250,000+ in it. Even if you have two solo 401(k)s (for some dumb reason) and the total is more than $250,000, you'll need to file this form.

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.

More information here:

Solo 401(k) Questions


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 $217,500 in income to max out a solo 401(k) in 2023, but you needed $330,000 to max out a SEP-IRA. This is because part ($22,500 in 2023) of the total $66,000 [2023] contribution is an employee contribution and doesn't enter into the employer contribution amount calculation. This income ($217,500 or $330,000 in 2023) 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, and it's 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

solo 401k vs sep iraSEP-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 for the Roth portion of SEP-IRAs. 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 for 2023 and $23,000 for 2024) can be designated as Roth contributions. This allows you some tax diversification benefits, and it also allows you to save more money in a tax-protected manner since after-tax money is worth more than pre-tax money. In fact, all $66,000 in 2023 ($69,000 in 2024) can be Roth if you do the Mega Backdoor Roth IRA process (see #5 below). The Secure Act 2.0 lessened this advantage, however, because starting in 2023, Roth contributions are now allowed in SEP-IRAs (although it's still hard for me to find one that actually allows it.)


#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 $7,500 [2023 and 2024] 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, take a careful look at a SEP-IRA. You can always roll it into a solo 401(k) 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!

[This updated post was originally published in 2020.]