Self-Employed? How to Choose Between a Solo 401(k) & SEP-IRA Retirement Savings

When building a career through self-employment or deciding to consult after retiring, a common question when starting is, "how should I save for my retirement if I don't have a company-sponsored 401(k)?" Consulting can yield substantial income even after leaving the corporate world, and there are many savings options available to you. Saving your self-employment income in tax-deferred retirement accounts, either through a Solo 401(k) or a SEP-IRA, can often be a beneficial way to continue building wealth to live off in your later years.

What's a Solo 401(K) & Who's It For?

A "solo 401(k)," or "Keogh defined contribution plan," is a retirement account for self-employed individuals who are running a business where they, and their spouse (if applicable), are the sole employees. A solo 401(k) works very similarly to a traditional 401(k), where both employers and participants can make contributions on a pre-tax or Roth basis with the contributions being taxed according to whichever contribution style you pick.

The business owner, or self-employed individual, functions as both the employee AND the employer. Therefore, he or she can make contributions to a solo 401(k) in both capacities.

• As an "employee," one can make elective deferrals up to the lesser of 100% of compensation or the annual limit.* 
• As an "employer," one can make profit-sharing contributions of up to 20% of their net adjusted business profit.**

What's a SEP-IRA & Who's It For?

A SEP (Simplified Employee Pension) IRA is a retirement plan available to employers, including self-employed people, with businesses exceeding one employee. For SEP-IRA plans, employers must contribute on behalf of their employees to the plan because an employee's elective salary deferrals and their accompanying catch-up contributions aren't allowed. The SEP-IRA functions similarly to a traditional pension plan in that only employers can contribute to the plan on behalf of the employee participant. 

Suppose your business has more than one employee (spouses are an exception). In that case, you'd be better off looking into a SEP-IRA account instead of a Solo 401(k), as Solo 401(k) accounts are limited to single-employee businesses and a designated spouse. Additionally, if you are projecting to make over approximately $264,000 in income and want to defer the maximum 25% contribution of your income, a SEP-IRA contribution would be similar to what you could contribute to a Solo 401(k). Keep in mind that you will have to contribute the same percentage you are contributing for yourself for all your employees, which could be a limiting factor if you have numerous and/or highly compensated employees. 

Differences Between Solo 401(k) & SEP-IRA for Self-Employed Professionals

Many freedoms and responsibilities come with running your own business. If you've technically 'retired,' solo 401(k)s can enable you to take advantage of tax deductions and deferrals as you continue to cushion your nest egg for the years to come. If you're still accumulating savings to put toward your retirement goals, a solo 401(k) offers two significant benefits compared to similar options. 

Key Difference 1 - Multiple Contribution Sources for Retirement Savings

Solo 401(k) Contributions can be made as both employer & employee

Like a traditional 401(k) plan, a solo 401(k) allows both an employer to contribute and the participant to make both pre-tax and Roth contributions. The IRS determines annual contribution limits for 401(k)s each year. There are two ways you can contribute to a solo 401(k): employee contribution (also referred to as elective deferral) or through employer contributions (commonly through profit sharing).

As an employee, contributing to a solo 401(k) is quite simple. Through pre-tax or Roth contributions, the maximum employee contribution amount you can put into a 401(k) in both 2023 is $22,500 if you're under age 50. If you are 50 or older, you can make an additional catch-up contribution of $7,500 for 2023, bringing your total maximum employee contribution to $30,000 each year.

In your concurrent role as the employer, when contributing to a solo 401(k), you can contribute up to 20% of your net adjusted business profit so long as you don't exceed the IRS' overarching limits for solo 401(k) contributions (including your contributions in your role as the employee). 

For 2023, the overarching solo 401(k) contribution maximum is $66,000 for participants under age 50. For participants age 50 or over, the maximum contribution to a solo 401(k) in 2023 is $73,500 ($66,000 + $7,500 catch-up). 

How to Determine the Employer Profit Sharing Contribution Amount to a Solo 401(k)

Above, we mentioned that a common way for employers to contribute to a Solo 401(k) is through profit sharing. A common question we get from our clients is how to determine the right contributions from profit sharing to their Solo 401(K). 

Let's walk through an example of how you can determine the appropriate profit-sharing contribution for your situation. Consider that you're a sole proprietor (age 52) who earned $100,000 after the deduction of business expenses.

In the situation outlined below, you could allocate nearly half of your yearly earnings to a tax-deferred retirement account. 

1. 1. Calculate Your Net Income & Self-Employment Tax
   The self-employment tax is 15.3% on taxable income for social security and Medicare. Only 92.35% of your self-employment income is generally subject to self-employment tax, so your total taxable income is calculated as: 
   

   Net Self-Employment Income ($100,000) is only taxed for the first 92.35% (.9235)

   100000 * 0.9235 = Taxable income ($92,350)

   Taxable Income ($92,350) * Self-Employment Tax (.153) = Self-Employment Tax ($14,129.55) 

   You may deduct up to half of your self-employment tax amount from your net self-employment income. This calculation helps to determine your net adjusted business profit. 
   
   

2. Calculate Your Net Adjusted Business Profit

Net Self-Employment Income after Business Expenses ($100,000)
- 1/2 of Self Employment Tax ($14,129.55/2 =$7,064.78)
= Net Adjusted Business Profit ($92,935.23)

From here, we can determine your maximum profit-sharing contribution alongside your maximum employee contributions. 

• • • 2023 Maximum Employee Contribution Amount (for those age 50 or over): $30,000
    • Maximum Profit-Sharing Contribution is up to 20% of net adjusted business profit: $18,587 (20% * $92,935.23)
    • Total contribution amount: $48,587

Similar to the Solo 401(k), the SEP-IRA is constrained to the contribution limits listed above as well. A key difference is that an employer’s contributions cannot exceed those limits or 25% of the employee’s compensation, whichever is less. Remember, an employee isn’t permitted to make elective deferrals for a SEP-IRA. Similar to a traditional pension, contributions are only made by the employer.

Key Difference 2 - Solo 401k Plans Often Afford An Individual More Contributions Than SEP or Traditional IRAs

Compared to other tax-deferred plans available, the solo 401(k) plan often allows a self-employed person to achieve the most funds. Many who start their own business look into alternative retirement savings plans, one of the most common is a SEP-IRA.

A key caveat of the SEP-IRA is that you, as the employer, must replicate any percentage of contributions you choose to make to your plan for your employee as well. For example, if you wish to contribute 20% of your compensation towards your SEP-IRA, you, as the employer, would also need to contribute 20% of your employee's salary to their SEP-IRA as well. 

A SEP-IRA has different, albeit similar, contribution limits compared to a solo 401(k). The IRS limits an employer's total SEP-IRA contribution to either $66,000 (2023) if 50 or over, or up to 25% of compensation, whichever of these contributions is lesser.  For participants under 50, the maximum SEP-IRA contribution amount remains at $66,000 because there are no catch-up contributions allowed for a SEP-IRA. But again, only if it's the lesser of the two options.

Let's illustrate how the solo 401(k) plan compares against the SEP-IRA and a Traditional IRA through an example. 

Suppose you're self-employed (age 51) and have earned $100,000 in income that's considered for these plans. If you've maxed out your contributions as both employee and employer, the maximum amount you can save in 2023 is as follows: 

In the example above, contributing to a Solo 401(k) instead of a SEP-IRA could help you save an additional $23,587!

Important Dates to Consider When Setting Up a Solo 401(k) or a SEP IRA

When setting up a SEP-IRA, you have until the date your tax return is filed (including extensions) to set it up, contribute, and receive a deduction on your tax return. For example, with an extension, the deadline to file your tax return is October 15, 2024. You have until October 15, 2024, to open and fund the SEP-IRA to receive the deduction on your 2023 return.

Unlike a SEP-IRA, a Solo 401(k) must be established in the year in which you take the deduction on your tax return. For example, you must set up the 401(k) plan before December 31, 2023, to receive a deduction on your 2023 tax return. The good news is that once the plan is established, you have until you file your tax return (including extensions) to contribute to the 401(k).

If you're considering using a solo 401(k) to help save for your retirement, you should remember the following dates:

1.  You can make contributions to a solo 401(k) for the 2023 tax year before you file your tax return as long as you opened the solo 401(k) plan before December 31, 2023.
2.  If you are consulting in 2023 and are interested in contributing to a solo 401(k), it's pertinent to open the plan before December 31, 2023.*

How to Choose Between a SEP IRA or Solo 401(K) Based on How Much Income You Expect to Earn 

An important consideration in deciding your business's optimal retirement savings plan is how much income you expect to earn. Your income will ultimately determine the maximum contribution you can make.

In general, if you earn less than approximately $264,000, a Solo 401(k) is the best way to maximize your contributions; Above that number, the maximum contributions will be the same for Solo 401(k) and SEP-IRA, given how the math works. 

Deciding to become self-employed is a significant life decision that impacts your life today as well as your retirement down the road. Keeping track of deadlines for contributions and tax deduction rules for these plans can be a nuanced and tedious task on a business owner’s seemingly endless list of to-dos. Working with an advisor with expertise in the financial and tax implications of each of these plans can offer peace of mind and allow you to focus on what matters most. We’ve helped several of Houston’s small business owners select the right plan for their long-term goals. To set yourself up for success, reach out to our team for expert guidance so your wealth can grow alongside your business.