Both the SEP IRA and the Solo 401K are self-employed retirement plans. They can be established by legal entities (in this context, often S corporations) or they can be established by individuals that have self-employed income. That self-employment income generally must come through a sole proprietorship or through a limited liability company (LLC) that is disregarded for tax purposes and reported on a Schedule C filed with the individual’s tax return.
A SEP IRA allows only for “employer” contributions. For this purpose, your own sole proprietorship or disregarded LLC can be your employer.
Generally, the employer can make annual contributions of up to 25 percent of eligible W-2 compensation (from a corporation) or 20 percent of an individual’s self-employment income, limited to $56,000 of contributions in 2019 and $57,000 of contributions in 2020.
The SEP IRA has the latest deadline of all the small business retirement plans. A SEP IRA can be established for a tax year by the deadline for filing that tax year’s tax return, including extensions.
The administrative compliance burden of a SEP IRA is generally very manageable.
A Solo 401K (also referred to as an Individual 401K) is a 401K plan established by a self-employed individual for their own benefit.
The main advantage of the Solo 401K is that it allows annual contributions by the self-employed individual in his/her role as the “employee” and annual contributions by the self-employed individual (or S corporation) in his/her role as “employer.”
Employee contributions are limited to the lesser of earned income or $19,500 ($26,000 if 50 or older) in 2020. Employer contributions are limited to up to 25 percent of eligible W-2 compensation (from a corporation) or 20 percent of an individual’s self-employment income, limited to $57,000 of contributions in 2020. Total employee and employer contributions are limited to $57,000 ($63,500 if age 50 or above) in 2020
The administrative compliance burden of a Solo 401K is generally very manageable, but note that once there are $250,000 or more of assets in the plan, you must file a Form 5500.
In the end
At this point, you might be saying, “Great, both the SEP IRA and Solo 401K are attractive. Is there really a big difference between them? Should I care too much about which plan I establish?”
The answer is that in most cases, the Solo 401K is the much better option for a self-employed person. If you are considering a SEP IRA over a Solo 401K in a situation where you qualify for both, you ought to think twice about that decision.
If you qualify for both, generally the Solo 401K is better than a SEP IRA. If you are going with a SEP IRA over a Solo 401K, you should understand the reasons for doing so. Finally, self-employed retirement plans is an area that taxpayers usually benefit from receiving personal advice from a qualified tax advisor. Speaking to a trusted advisor is imperative when making these financial decisions.