SEP IRA versus Solo 401(k)-Which is Better?

By in Advanced Investing, Investing, Reader Question, Retirement, Saving | 14 comments

Your Investing Questions Answered

My inbox is filled with investing questions from personal finance bloggers.

When I first offered to respond to their investing questions, I expected a few simple queries that I could answer in a paragraph or two.

I was wrong!

The investing questions keep coming in and they are complicated.

Due to the vast number of questions, Thursday’s will be investing question and answer day.

SEP IRA versus Solo 401(k)

A big shout out to one of my favorite personal finance bloggers, Robert of The College Investor who jumped in with this question:

“What’s the best option for the self-employed – a SEP IRA or a Solo 401k?  What are the pros and cons of each?  Does the amount of income you make matter for your choice?” Robert of The College Investor 

SEP IRA or Solo (401)?

What is the Difference Between a SEP-IRA and Solo 401(k)?

Fortunately, I just did a comprehensive article on the ins and outs of a SEP -IRA. As a quick refresher, A SEP IRA is similar to an individual traditional IRA yet allows much larger contributions for the self employed, freelancer, or solopreneur. This type of retirement plan allows the employer (even one without employees) to contribute up to 25 percent of an employee’s salary (capped at $51,000 in 2013) into this retirement vehicle.

A SEP IRA allows an employer to contribute up to 25 percent (with a maximum contribution of $51,000 in 2013) of each eligible employee’s salary into a specially set up Traditional IRA for that employees future. The contributions are allowable even if you are the employer and employee! Since the SEP IRA is discretionary, the employer can choose to contribute one year without the obligation to contribute the next.

The solo 401(k) is set up for someone running their own business or one with an immediate family member. The contribution limits for this type of retirement plan are the same as those for a company sponsored 401(k) but the sole proprietor can make an additional contribution as well. The small business owner acts as employer and employee when funding a solo 401(k). She can contribute as the “employee” and the “employer” to an independent 401(k), thus increasing the total contribution limit.

In 2014, an individual can contribute up to $17,500 to a solo 401(k) and those over 50 can allocate an additional $5,500. The employer part of the contribution can add up to an additional 25 percent of compensation. The maximum annual contribution is capped at $$51,000 (not including catch up contributions) for 2013 and $52,000 for 2014. If you make $200,000 per year and are older than 50, you can contribute $51,000 plus $5,500 catch up contributions for a total of $56,500 to your solo 401(k).

Continuing with the same example, the entrepreneur making $200,000 with a SEP IRA can contribute a maximum of $51,000 with no catch up contribution. This calculation is a bit tricky because you need to take into account a deduction for self-employment tax. Then there’s a contribution rate formula that is used. According to Vanguard’s plan contribution calculator, the SEP IRA allows for a $38,054.49 contribution.

Pro’s and Con’s of a SEP IRA

  • Pro: Easy to set up and minimal administrative responsibilities.
  • Pro: High contribution limit; $51,000 for 2013.
  • Pro: SEP IRA can be converted to a solo 401(k) if desired.
  • Con: No additional $5,500 catch up provision for those age 50 and older. Solo 401(k) may allow greater contribution for older high earners.
  • Con: IRS does not allow loans from a SEP IRA.

Pro’s and Cons’s of a Solo 401(k)

  • Pro:  High contribution limit; $51,000 for 2013 plus $5,500 catch up contribution for those over 50. Calculation method usually allows for higher contributions than the SEP IRA.
  • Pro: Able to borrow (tax free) from solo 401(k) if necessary.
  • Con: Greater administrative responsibilities and costs than for SEP IRA.

The Answers

What’s the best option for the self-employed – a SEP IRA or a Solo 401k? It depends. If you don’t foresee needing to borrow from your retirement account and aren’t earning enough to be concerned with the lower contribution limit of the SEP-IRA then this is probably the simplest retirement savings vehicle for you.

If you like the option of being able to borrow from and make larger contributions to the plan, then the solo 401(k) may be a better choice. Just be ready for more paperwork.

Does the amount of income you make matter for your choice? Yes, in most cases, the solo 401(k) allows for higher retirement plan contributions.

Do you have a retirement account? What type of account and why did you choose it?

 

 

    14 Comments

  1. I have a 401K, where I save 15% per month, and a Roth IRA where I try to max out each year. Thanks for the reminder about retirement saving.

    MonicaOnMoney

    December 18, 2013

    • @Monica, Maxing out retirement investing opportunities, with diversified index funds may be the best long term wealth builder there is!

      Barbara Friedberg

      December 18, 2013

  2. One of the best explanations I’ve seen on the difference between these two accounts! Great job Barb!

    Moneycone

    December 18, 2013

  3. Great overview and description of the two Barb! We went back and forth between the two for my wife and I and decided on a SEP for us both. I like that we could contribute more in the 401k, but don’t see ourselves needing to take out a loan and like the less paperwork. It is a terribly huge issue, but many brokerages charge an admin fee for solo 401ks where you really don’t run into that with the SEP.

    John S @ Frugal Rules

    December 18, 2013

  4. I went with solo 401k.
    I thought you can contribute more with solo 401k.
    When I use an online calculator, it shows the SEP IRA contribution limit is much lower than solo 401k.
    I guess if you have SEP IRA, you need to open a separate traditional IRA account to contribute another $17,500?

    Joe

    December 18, 2013

  5. The small company that I started my engineering career with had a SEP-IRA until we had over 50 employees and had to move to a 401(k). The SEP was great and had all the investing choices of a regular IRA.

    Bryce @ Save and Conquer

    December 18, 2013

  6. @Moneycone- Thank you
    @John-I also like the simpler option with the SEP but as you said, the decision is really personal and depends on one’s circumstances.
    @Joe, You are correct, in most circumstances the solo 401(k) allows for higher contributions. The traditional IRA has much lower contribution limits. According to the IRS
    “For 2013 and 2014, the maximum you can contribute to all of your traditional and Roth IRAs is the smaller of:
    $5,500 ($6,500 if you’re age 50 or older), or
    your taxable compensation for the year.”

    Barbara Friedberg

    December 18, 2013

  7. @Bryce- Depending upon the administrator of the plan, the investment choices are not necessarily impacted by the type of account.

    Barbara Friedberg

    December 18, 2013

  8. Thanks for answering my question. I went with a SEP-IRA but a few friends told me I should have gone with a 401k. Now based on your answer, I’m happy having a SEP-IRA!

    The College Investor

    December 18, 2013

  9. Hi Robert,
    Glad I removed your “buyers remorse”. I hope you earn the max and can contribute $51,000 to your SEP IRA 🙂

    Barbara Friedberg

    December 18, 2013

  10. I always thought a solo 401k is better for people earning average incomes on their schedule C. Being able to contribute $17,500 and not necessarily 25% of their income was a draw for me when trying to determine which was best for my wife (self employed hairdresser). Thanks for the post Barbara and nice question Robert!

    Tortoise Banker

    December 18, 2013

  11. This is great – thanks! I’m looking forward to the series.

    I went with Solo K because it seems easier to contribute, and I also like having the ability to make Roth 401k contributions. It’s kind of like one stop shopping for me.

    FF

    December 18, 2013

  12. As a self employed individual, you have a number of choices to shelter your income. When I owned apartment buildings and businesses, I used depreciation because I owned assets.

    krantcents

    December 18, 2013

  13. @FF-THanks for weighing in. Clearly, there’s no “right” answer to this question:)
    @Tortoise-AGreed, it’s nice to have the higher contribution limits if you can swing it. I am a big advocate of stuffing as much cash into retirement savings, especially in your younger years (more time to compound).

    Barbara Friedberg

    December 18, 2013

Trackbacks/Pingbacks

  1. Tax Tips for High Income Investors | Barbara Friedberg Personal Finance - […] That includes a 401(k), 403(b), SEP-IRA, traditional IRA, Roth IRA. […]
  2. Term Insurance: Not Always the Right Answer | Barbara Friedberg - […] 1. SEP IRA versus Solo 401(k); Which is Better? […]

Post a Reply

Your email address will not be published. Required fields are marked *