Solo 401(k) vs. SEP IRA: What’s the difference?

If you’re a small-business owner or employee, you might be looking for a way to maximize your retirement savings. You may have even checked out a variety of options including solo 401(k) plans and SEP IRAs.

Both were designed with small businesses in mind. And both can offer attractive tax advantages to business owners and their employees. But there are key differences when it comes to things like eligibility, contribution limits and whether participants can take out loans against their plans.

Key takeaways

  • Solo 401(k) plans and SEP IRAs are two retirement options designed for small-business owners and employees.
  • With both plans, participants set aside either pretax dollars or after-tax dollars and allow them to grow until retirement.
  • Key differences between the plans include eligibility and contribution requirements.
  • Catch-up contributions are another difference. A solo 401(k) plan allows people over 50 to make them but a SEP IRA doesn’t. 
  • With both plans, ease of setup and administration are key benefits for business owners.

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What is a solo 401(k)? 

A solo 401(k) plan is a retirement savings account for self-employed people and their spouses if the spouse also works for the business. The plan is also known by names like self-employed 401(k) and one-participant 401(k). According to the IRS, a solo 401(k) plan is governed by the same rules and regulations as a traditional IRA

One of the advantages of a solo 401(k) plan is its tax benefits, which apply whether the participant chooses to contribute pretax or after-tax dollars. A solo 401(k) plan also offers generous contribution limits compared with some other retirement plans. Plus, business owners benefit from the simplicity of establishing and maintaining solo 401(k) plans compared with other types of retirement plans.

What is a SEP IRA? 

A SEP IRA, or Simplified Employee Pension Individual Retirement Account, is a type of retirement savings plan. It was designed with self-employed people and small-business owners in mind but can be offered by companies of any size. SEP IRAs are employer funded. That means the business owner contributes to the plan, not the employee.

With a SEP IRA, contributions can be made with either pretax or after-tax dollars, depending on the plan. Both options offer tax advantages. A SEP IRA’s simplicity is another advantage for business owners since the plan is typically easier to set up and administer than other types of retirement plans are. 

Differences between solo 401(k) plans and SEP IRAs

While solo 401(k) plans and SEP IRAs are both retirement plans, they have some major differences. Here’s how they compare:

Eligibility 

Solo 401(k) plans have narrower eligibility requirements than SEP IRAs do. That’s because solo 401(k) plans are available only to self-employed people and their spouses who also work for the company. 

But SEP IRAs, which are common for self-employed people and small businesses, can be offered by any business. 

Contributions

Retirement accounts typically have a contribution limit that caps the amount that can be invested in the plan each year. Here are contribution limits and related details for both plans for 2023:

  • Solo 401(k) plans: A self-employed business owner can make contributions to their plan as both employer and employee. They can set aside up to 100% of their compensation as an employee contribution, with a limit of $22,500. They can also set aside up to 25% of their business’s income or $66,000, whichever is lower. Participants who are 50 and over can also make catch-up contributions to their plan of up to $7,500.
  • SEP IRA plans: An employer can contribute a maximum of 25% of their business’ income or $66,000, whichever is less. Keep in mind that the business owner makes the contributions in this type of plan, not their employees. And the owner is required to contribute the same percentage of income to every eligible employee’s plan, including their own. With a SEP IRA, catch-up contributions for participants over 50 aren’t an option.

Roth options 

Some retirement plans offer what’s known as a Roth option. It allows participants to make contributions on an after-tax basis. One advantage of having a Roth plan is that withdrawals made by a participant during their retirement years won’t be taxed. 

Solo 401(k) plans offer a Roth option. So do SEP IRAs. That started in 2023 thanks to the SECURE Act 2.0 legislation.

Tax benefits 

The tax benefits for both plans depend on things like your financial situation and eligibility. But here’s one key thing to keep in mind: The difference between traditional and Roth options largely comes down to when the contributions to your plan are taxed. 

It may help to talk to an accountant or other financial expert to decide which option is best for you.

Participant loans

If their plan allows it, the IRS gives solo 401(k) participants the option of taking a loan against their plan and then paying themselves back with interest.

401(k) plan participants can borrow up to $50,000 or 50% of their vested account value, whichever is less. Loans against a 401(k) plan typically come with requirements for things like how quickly the loan has to be repaid. Failing to repay it in time could result in additional taxes and penalty fees. 

Participants in a SEP IRA don’t have the option of taking out a loan against their plan.

How to decide whether a solo 401(k) or a SEP IRA is right for you

It’s not always easy to decide between retirement plans, especially when you can’t make an apples-to-apples comparison. Talking to a qualified financial expert might be helpful. In the meantime, here are some key things to consider when you’re evaluating solo 401(k) plans and SEP IRAs: 

  • Annual contribution limits: In 2023, the contribution limits for both plans are relatively similar. 
  • Investment options: Typically, SEP IRAs offer a range of investment options including CDs, mutual funds, stocks, money market funds and savings accounts. Solo 401(k) plan participants have fewer choices, with mutual funds being a major investment category.
  • Solo 401(k) plan contribution advantage: A solo 401(k) plan allows business owners to make contributions as both employee and employer. The employer contribution has the additional advantage of reducing the owner’s business taxes while they’re working to build their savings. But keep in mind that the solo 401(k) plan isn’t an option for all business owners—just a self-employed person and their spouse who works for the company. 
  • SEP IRA requirement for equal contributions: SEP IRAs require business owners to make equal contributions to all eligible employees, including themselves. For example, if they want to contribute 10% of the business’s income to their own plan in a given year, they have to do the same with every other employee with the plan. 
  • Catch-up contributions: While a solo 401(k) plan allows for catch-up contributions for participants over 50, a SEP IRA does not. 

Solo 401(k) rollover to SEP IRA: How does it work?

The IRS allows solo 401(k) plan participants to roll their funds into other types of retirement plans, including SEP IRAs. Fund participants are typically limited to one rollover in any 12-month period, and they have to complete the rollover within 60 days.

To start the process, the 401(k) plan participant can request a distribution from their plan to be paid to them, and then they make the deposit into their SEP IRA. Other options include having their financial institution or plan administrator transfer the funds. When the participant files their federal income taxes, they’re required to report the amount of the distribution even though it won’t be part of their taxable income.

Can you have a SEP IRA and a 401(k)?

In general, it’s possible to have both a SEP IRA and a 401(k) plan. There are some limitations, though, based on how the plans are set up. One key requirement is that the SEP IRA plan and the 401(k) plan have to be offered through different companies.

Solo 401(k) vs. SEP IRA in a nutshell

Solo 401(k) plans and SEP IRAs are potential choices for a small business looking to offer its employees a retirement plan. Each offers tax advantages and other benefits including ease of setup and administration. 

If you’re planning for retirement and trying to gauge how much you should set aside, check out Capital One’s guide on how much you need to retire.

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