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).
- 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).
- 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.
- 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.
- 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.
- 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
How to Open a Solo 401(k) at Fidelity
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:
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
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 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?
[This updated post was originally published in 2011.]
“You can always roll it into a solo 401(k) (well, except at Vanguard) later”
What’s the issue with rolling a SEP IRA into a 401k at Vanguard?
It’s an old problem. The used to not allow IRA rollovers into Vanguard solo 401(k)s. That is no longer the case. It changed a couple of years ago.
Do I have to roll my SEP-IRA into a solo-401(k) if I switch over? Or just leave it where it is ??
My CPA is looking into switching me from LLC to S-Corp, and possibly hiring my wife. Like the idea, as it should (in theory) lowering my taxes as she would be in a lower group, although we do file jointly, so not sure how that works.
Maxing out as much as I can, but with each year limits going up (a good thing), possibly hiring my wife to lower taxes (I guess a good thing), kids tuition costs/property taxes,COL, etc going up every year (a bad thing), and working hourly without a raise in 5 years ( not happy there), the only way I can make more is work more ( a bad thing). Have talked to a few financial advisors and others, I get 6 different answers from 5 people, and none of them are the same. Condused to say the least.
You don’t have to, but if you don’t and you do a Backdoor Roth IRA, the conversion step will be pro-rated.
The point of hiring your wife is usually to get her some additional quarters for SS or to make some more 401(k) contributions, but it usually increases your payroll taxes. You should definitely know WHY you’re doing that. Not sure why you or your accountant think it’ll lower your taxes other than via a big 401(k) contribution for her.
I am an Independent Contractor and contributed a small amount to SEP IRA this year. Is it possible to do a Solo 401k for this year and contribute to it for this year? If yes, what rules apply.
Thanks.
Yes. The SEP IRA and the Solo 401(k) will share the same contribution limit though so there’s no point. Just use one. I’d finish 2023 with the SEP IRA and start the solo 401(k) for 2024 and roll the SEP in there.
Thanks for the reply. I thought I can contribute upto $22,500 additional as employee contribution if I use solo 401k.
Good point. I guess if those are your only retirement accounts you could. Still not sure I’d have both in the same year. Lots of complexity there. It is allowed though.
Good post. Balanced appropriately.
A situation where the simpler SEP is better is for a lower dollar side hustle. I do Guidepoint surveys for a few grand a year. Consult for a couple pharm companies for a few grand. Typically in a good year barely 5 figures of 1099. So not huge dollars but might as well get extra retirement money in. So I calculate the max based on the income and put it my SEP and roll into my Roth IRA next day. Just a way to get a little extra into my Backdoor Roth each year. For small amount the SEP is very simple and gets the job done and you don’t have to worry about pro rata rule if you roll to Roth right away. SEP acct is just a pass through for me at vanguard into my Roth.
I was considering this as well. I made just under 5 figures of 1099 for 2023. I was considering contributing to SEP and rolling into my employer 401k which they said they would accept. I see this is another option to roll into the Roth IRA (or do a Roth SEP once commercially available). It is a small amount of taxes, but have to consider if the Roth money is more valuable than the tax break. How did you weigh the 2 options? Does the contribution and rollover out of the SEP need to be done before Dec 31 or just before April 15 to not mess up my back door Roth IRA? Thanks!
Before Dec 31st.
SEP can be before april 15. I usually see the total for my 1099 and after december and calculate from there and put into the sep. couple days later roll into my roth.
Good point. If you make your contribution in the next calendar year and then the conversion in the same year, there’ll be no pro-rata issue with Backdoor Roth IRAs.
Hello Dr. Dahle,
Does the pro rata rule apply to pension accounts like ohio OPERS and STRS ohio ( teachers’ pension account), I assume they are not considered IRA accounts but wanted to check your thoughts?
thanks alot
No.
Contributing to a traditional SEP IRA and then converting to Roth IRA will lose 199A deduction, right.
(I think this was alluded to in the post but I want to make sure)
A SEP IRA contribution could get one into the range where you could take a 199A deduction. But converting it would reverse that effect.
Right. If you are already in the range, every dollar contributed to a traditional SEP will reduce the 199A deduction, right? This is even if you convert to a Roth IRA after, paying 100% income tax on that conversion instead of the 80% tax you would have paid without contributing to SEP.
It would reduce your OBI so yes.
Does anyone have a ROBS 401k? What provider are you guys using for your 401k investments? None of the 401k providers I’ve had recommended to me support the ROBS 401k plans.
I’m not a big fan of using your 401(k) money to start your business. Are you sure you want to do that?
If you really do, Google says these folks do it:
https://www.guidantfinancial.com/401k-business-financing-robs-guide/how-rollovers-for-business-startups-work/
https://www.benetrends.com/robs-401k-funding/
I have two 1099 side gigs that I have not been fully capitalizing on. I want to be clear what percent I can save in a SEP-IRA. I’m also my own employer though. My practice is an LLC and I’m the only physician. What are my options for saving more through my LLC?
First of all, “two 1099 gigs” are a single business. So one set of retirement accounts for that.
As a general rule, for someone with a very profitable 1099 business who wants to save as much as possible into retirement accounts, the best combination of accounts is a solo 401(k) plus a personal defined benefit/cash balance plan. A SEP IRA is generally considered an inferior account. While a SEP is slightly simpler than a solo 401(k), the 401(k) is just so much better in so many ways that it’s usually the wrong move for a doc to use a SEP-IRA at all.
The fact that the business is an LLC doesn’t matter one lick. The IRS basically ignores LLCs and treats them either as a sole proprietorship, a partnership, or a corporation. If a corporation, it can be treated as a C or an S Corp.
Hope that helps. If you have additional questions please ask.