What's the difference between SEP IRA and Solo 401(k) for self-employed?

SEP💡 Definition:A time frame allowing you to enroll in health coverage outside the annual open enrollment, crucial for timely access to care. IRA💡 Definition:A retirement account with tax-deductible contributions that grow tax-deferred until withdrawal in retirement. vs. Solo 401(k): Which is Right for Your Self-Employed Retirement💡 Definition:Retirement is the planned cessation of work, allowing you to enjoy life without financial stress. Savings💡 Definition:Frugality is the practice of mindful spending to save money and achieve financial goals.?

When you're self-employed, saving for retirement can seem daunting, but fortunately, there are tax-advantaged retirement plans designed specifically for people like you. Two popular options💡 Definition:Options are contracts that grant the right to buy or sell an asset at a set price, offering potential profit with limited risk. are the SEP IRA and the Solo 401(k). Although they both offer significant benefits, their differences can make one more suitable for your situation than the other. Let's delve into these plans to help you decide which might be the best fit for your retirement savings goals.

Understanding the SEP IRA

A Simplified Employee 💡 Definition:A retirement account for self-employed individuals and small business owners allowing contributions up to 25% of income or $69,000 (2024).💡 Definition:An annuity is a financial product that provides regular payments over time, crucial for retirement income planning.Pension💡 Definition:A pension is a retirement plan that provides regular payments, ensuring financial security in your later years. (SEP) IRA is attractive for its simplicity and relatively low administrative burden. Here's what you need to know:

• Contribution Limits: As a self-employed individual, you can contribute up to 25% of your net self-employment💡 Definition:Freelancing offers flexibility and independence, allowing you to earn income on your own terms. income, capped at $69,000 in 2024 and $70,000 in 2025.
• Eligibility: The SEP IRA is suitable for businesses that anticipate hiring employees because contributions must be made for all eligible employees.
• Administration: With minimal paperwork and no annual filing requirements, managing a SEP IRA is straightforward.
• Tax Benefits: Contributions are tax-deductible💡 Definition:The amount you must pay out-of-pocket before insurance coverage kicks in., and the funds grow tax-deferred💡 Definition:Income or contributions made before taxes are withheld, reducing current taxable income. until withdrawal in retirement.
• Restrictions: There's no option for Roth💡 Definition:A retirement account funded with after-tax dollars that grows tax-free, with tax-free withdrawals in retirement. contributions or catch-up💡 Definition:Extra retirement contributions allowed at age 50+. 401k: additional $7,500/year. IRA: additional $1,000/year. Helps late savers close gap. contributions for those aged 50 and over.

Exploring the Solo 401(k)

A Solo 401(k), also known as an individual 401(k), offers greater flexibility and higher contribution potential, especially for high earners:

• Contribution Limits: You can contribute as both employee and employer. In 2025, the employee contribution limit💡 Definition:A contribution limit is the maximum amount you can legally invest in a financial account, helping you save effectively. is $23,500, with a $6,500 catch-up for those 50+ and an additional catch-up for ages 60–63. Employer contributions can be up to 25% of net 💡 Definition:Income is the money you earn, essential for budgeting and financial planning.earnings💡 Definition:Profit is the financial gain from business activities, crucial for growth and sustainability., with a combined total limit of $70,000 (or $76,500+ with catch-up).
• Roth Option: Unlike the SEP IRA, the Solo 401(k) allows for Roth contributions, which grow tax-free.
• Loan Provision: You can borrow from your Solo 401(k), up to $50,000 or 50% of the account balance.
• Eligibility: Best suited for sole proprietors or businesses with only the owner and their spouse as employees.

Real-World Scenarios

To illustrate how these plans work, consider a freelance graphic designer earning $100,000 annually:

• Solo 401(k) Contributions: The designer can contribute $23,500 as an employee and an additional $25,000 as an employer in 2025, totaling $48,500. If they are over 50, they can contribute up to $56,000 with catch-up provisions.
• SEP IRA Contributions: For the same income, the maximum contribution would be $20,000, calculated as 20% of net earnings after self-employment tax💡 Definition:Tax withheld from employee wages.

If this freelancer decides to hire a full-time employee, the SEP IRA remains a viable option due to its flexibility in accommodating additional employees. However, the Solo 401(k) would need to be terminated or converted since it no longer qualifies with additional employees.

Common Mistakes and Considerations

When choosing between a SEP IRA and a Solo 401(k), consider the following:

• Administrative Burden: A Solo 401(k) requires more administrative work, including filing Form 5500-EZ if your plan’s balance exceeds $250,000.
• Contribution Obligations: SEP IRA contributions must be made for all eligible employees, not just the owner.
• Roth Contributions: While Solo 401(k) Roth contributions grow tax-free, they are subject to income limits and other restrictions.

Bottom Line

Both SEP IRAs and Solo 401(k)💡 Definition:An employer-sponsored retirement account where you contribute pre-tax income, often with employer matching.s offer powerful ways to save for retirement, but the best choice depends on your specific circumstances and financial goals. If you value simplicity and anticipate hiring employees, a SEP IRA might be suitable. For those seeking maximum contribution potential, Roth options, and loan flexibility, a Solo 401(k) could be the better choice. Consider your earnings, business structure, and future plans carefully to select the plan that aligns best with your needs. Always consult with a 💡 Definition:A fiduciary is a trusted advisor required to act in your best financial interest.financial advisor💡 Definition:A financial advisor helps you manage investments and plan for financial goals, enhancing your financial well-being. or tax professional to ensure you make the most informed decision.