The simplified employee plan–individual retirement account (SEP-IRA) has long been the star option for sole proprietors seeking to reduce income taxes and save for retirement beyond the lower contribution limits of traditional individual retirement arrangements (IRAs). However, with discount brokerage firms’ improvements in ease of account establishment and management, the IRS-termed one-participant 401(k) plan, often referred to as the solo 401(k), is growing in popularity.
On the surface, the solo 401(k) may appear to be unquestionably the preferable option due to having a higher potential contribution amount, along with the low fees and vast suite of investment options that SEP-IRAs have always enjoyed. In addition to the employer contribution, which is calculated in the same manner as the SEP-IRA contribution maximum, 401(k) holders may also elect up to the annual employee deferral limit, which is $23,000 ($30,500 for age 50+) for tax year 2024, so long as their business generated enough net profit.
However, several nuances make this a more complicated choice for clients beyond just asking them if they want to maximize tax-favored savings limits.
This article offers a high-level overview of some of the most common considerations when choosing between the SEP-IRA and the solo 401(k) but does not cover every aspect of the differences between the two accounts. For a deeper dive into the solo 401(k) and all of the nuances to consider, a suggested book is Solo 401(k): The Solopreneur’s Retirement Account by Sean Mullaney, CPA.
Contribution limits
The most notable difference between the SEP-IRA and the solo 401(k) is that, as discussed below, the 401(k) allows sole proprietors to contribute more, up to $69,000 in 2024 ($76,500 for age 50+) if there is enough compensation to support it, without having to have the full $345,000 in net profit for the year that would be required to contribute the same amount to a SEP-IRA.
SEP-IRA holders are limited to contributing 25% of earned income. Earned income is calculated by taking the net profit of the business and deducting both one-half of the self-employment tax assessed on it as well as any tax-deductible contributions made to the SEP-IRA for the account holder.
In comparison, solo 401(k)s generally allow higher contributions because there is both an employer and an employee contribution, and the latter is not subject to the 25% restriction. The difference is illustrated below.
SEP-IRA contribution max calculation:
For example, Corey, a Schedule C sole proprietor who is age 38 and has a $150,000 net profit, can contribute a maximum of $27,881 to her SEP-IRA, assuming she wishes to deduct her contributions from her business profit. To arrive at that number, first she must calculate the plan’s reduced contribution rate based on her desire to deduct and contribute the full 25% allowed to her SEP-IRA as follows:
Next, we note the fact that she must pay $21,194 in self-employment taxes and use that to calculate her own contribution and deduction for that contribution, again assuming she elects pretax contributions.
Note that Section 601 of the SECURE 2.0 Act (enacted as part of the Consolidated Appropriations Act, 2023, P.L. 117-328) added the ability for SEP-IRA owners to elect to designate a Roth IRA as the IRA to which the contributions to the SEP-IRA are made. Any contribution under a SEP that is made to a Roth IRA is not excludable from the employee’s gross income.
Thus, electing to make SEP contributions to a Roth IRA would negate the need to calculate the reduced plan contribution rate, and one could jump straight to the below calculation using 25% as the contribution rate. In this case, Corey’s maximum allowed contribution would be $34,851 ($139,403 × 25%), which would also increase her qualified business income (QBI) amount due to the higher net profit overall.