What Is a SEP IRA
In 1978, due to concerns over the welfare of small businesses, Congress created the Simplified Employee Pension IRA (SEP IRA) to extend the IRA concept.
SEP IRAs benefit self-employed people, small businesses, and their employees through simple, tax-advantaged retirement savings accounts similar to personal individual retirement accounts.
Compared to a 401(k), SEP IRA accounts usually offer more options and are much broader. Most importantly, they offer more generous tax breaks than personal IRAs. In some cases, the tax deduction for a SEP IRA can be nearly 10 times that of a traditional IRA.
SEP IRA Eligibility and Contribution Limits
The following criteria should be met by eligible employees, as far as the IRS is concerned:
- At least 21 years old
- Worked for the company for three of the last five years
- Earned at least $650 in the past year
The contribution levels are set by the IRS for a given year, and generally stay the same from year to year. The employer may choose to make either a percentage of pay or a flat dollar contribution to each employee's SEP IRA account.
One feature of a SEP IRA is that only the employer can make contributions to the account. However, a solo entrepreneur or self-employed person may contribute as they also act as the employer.
For 2023, the maximum SEP IRA contribution is the lesser of $66,000 or 25% of adjusted net earnings. Accounting for exemptions, this works out to be about 20% of earnings for self-employed individuals, as calculated using IRS Publication 560.
SEP IRAs do not allow catch-up contributions for people aged 50 or older as employee contributions are not allowed. Funds paid into the SEP IRA are fully tax deductible up to IRS limits.
Setting up a SEP IRA
An SEP IRA is easy to set up since it is available in most major brokerage firms. It requires little to no administrative overhead.
Since this plan is available to companies even with a single employee, it can be a good choice for solo entrepreneurs or gig workers.
To set up your account, you first need to open an account with a brokerage firm. This is the easiest way to get started, and you will have a lot of investment options.
Next, you need to complete IRS Form 5305-SEP, a formal written agreement to set up a SEP IRA. However, most brokerage firms will take care of that on your behalf. For most firms, there are no annual fees or opening fees.
Pros and Cons of a SEP IRA
The SEP IRA has the following pros:
- Higher contribution limits than a 401(k)
- Allows you to deduct all your employer contributions when calculating your business taxes
- No annual fees or opening fees for most firms
- Allows making additional contributions to a traditional IRA or Roth IRA
The SEP IRA has the following cons:
- You are limited to investing in certain types of funds.
- SEP IRAs have many of the same restrictions as regular IRA accounts.
- If you withdraw money before reaching 59½ years old, this will be taxed as ordinary income plus a 10% penalty for early withdrawal.
- You will have to start paying required minimum distributions (RMDs) when you turn 73 to ensure that the government begins receiving taxes on your savings.
What Is a Solo 401(k)?
This plan may also be referred to as an individual 401(k), i401(k), or a one-participant 401(k).
A solo 401(k) is essentially a 401(k) plan that is generally limited to self-employed individuals, though spouses who work at least part time for them may also be eligible to contribute.
If you run a small business, you will be ineligible to save for this plan if the other employee is not your spouse.
A solo 401(k) may offer greater annual contribution limits and bigger tax deductions than a SEP IRA for self-employed people. It also allows you to make post-tax Roth contributions.
Solo 401(k) Eligibility and Contribution Limits
The eligibility requirement for a Solo 401(k) is simple:
- Anyone who profits from a sole proprietorship, Limited Liability Company, or other business organization without another employee other than their spouse.
In 2023, the annual maximum contribution is $66,000. Unlike a SEP IRA, one can make an additional catch-up contribution of $7,500 a year to a solo 401(k) for people aged 50 and older.
You must also note that this plan enables most workers to contribute more and receive higher tax breaks, since the solo 401(k) owner acts as both an employer and employee.
As an employee, you can contribute up to $22,500 in 2023. But as an employer, you can add up to 25% of your adjusted income on top of that for a maximum total contribution of $66,000 in 2023.
Setting up a Solo 401(k)
There are two ways to set up a Solo 401(k):
You can establish an account with an investment firm. This is the easiest way to get started, but you will have less control over your investments.
Self-Directed Solo 401(k) Providers
You can establish an account with a self-directed Solo 401(k) provider. This option gives you more freedom because you will be able to choose what types of funds and investments are offered in the plan. Some providers even let you invest in alternative investments, such as real estate, private equity, and hedge funds.
Pros and Cons of the Solo 401(k)
The Solo 401(k) has the following pros:
- It can be used by self-employed individuals who do not have employees.
- It offers more investment options than a SEP IRA because you will be able to choose from any fund or type of investment that is offered in the plan.
The only cons in setting up a solo 401(k) are that it is only worth it if you want to make large contributions and that it involves more paperwork.
Choosing Between a SEP IRA and a Solo 401(k)
Deciding between a SEP IRA and a Solo 401(k) will depend on your circumstances.
If you want to make large contributions, the Solo 401(k) is the best choice because it offers more investment options than a SEP IRA. However, this option has many additional rules that must be followed in order to contribute the maximum amount each year.
If you do not want to make large contributions, the SEP IRA is a better option because there are no annual contribution limits and it is easier to set up than the Solo 401(k). However, you will be limited to investing in certain types of funds.
Remember that both accounts offer tax breaks for contributing early, so decide which option is most beneficial for you.
Even though a solo 401(k) has higher maximum contributions, if you cannot afford to max it out every year, a SEP IRA might be the better option.
A SEP IRA is easier to set up and manage because there are no annual contribution limits. In addition, the SEP IRA is more flexible because you will be able to invest in any type of fund.
A Solo 401(k) has higher contribution limits and bigger tax deductions, but requires more paperwork. It also gives you the freedom to make post-tax Roth contributions.
If you want to make large contributions, a Solo 401(k) might be the better option. However, it is only worth it if you want to make big contributions and involves more paperwork.
1. What is a Solo 401(k)?
The Solo 401(k) is a retirement account for self-employed individuals. It allows people with no employees who are over 50 years old to catch up on their contributions every year.
2. What is a SEP IRA?
A SEP IRA is an Individual Retirement Account (IRA) that allows self-employed individuals and their employees to contribute money on a tax-deductible basis. Employers can make contributions for their employees, and employees can also make voluntary contributions.
3. What are the benefits of setting up a SEP IRA?
The SEP IRA has no annual fees or opening fees for most firms. You are also able to contribute more money than you can with a Solo 401(k). Additionally, the SEP IRA is easier to set up than a Solo 401(k).
4. What are the benefits of setting up a Solo 401(k)?
The Solo 401(k) offers more investment options than a SEP IRA. It can be used by self-employed individuals who do not have employees.
5. What are the cons of setting up a Solo 401(k)?
The Solo 401(k) is more difficult to set up and has many rules that must be followed in order to contribute the maximum amount each year.