Compare SEP IRA vs. Solo 401k – Advantages of a Solo 401k

We often hear from small business owners who are comparing a SEP IRA vs. Solo 401k.  For those who qualify for the Solo 401k, they will almost always find that a Solo 401k has certain features that make it the better option.  This post highlights several key advantages of a Solo 401k vs. SEP IRA.

SEP IRA vs. Solo 401k – Advantages of a Solo 401k

You can contribute more to a Solo 401k vs. SEP IRA 

Solo 401k allows for higher annual contribution limits than a SEP IRA. The reason for this is that a Solo 401k allows for both employee (salary deferral) & employer (profit sharing) contributions whereas only profit sharing contributions can be made to a Solo 401k.  To illustrate this point consider the following scenario: Karen is 54 years old & is the sole owner of an S Corporation with no full-time employees that provides accounting services.  If she earns $100,000 in self-employment W-2 wages for 2020, she will be able to contribute $51,000 for 2020 which consists of a $26,000 employee deferral and a $25,000 profit sharing contribution.  On the other hand, if Karen established a SEP IRA, she would only be able to contribute $25,000 for 2020 because the SEP IRA rules only allow for profit sharing contributions.  Visit Solo 401k contributions to learn more.

Solo 401k allows for Roth Contributions

For 2020 the self-employed business owner may make up to $26,000 in Roth contributions to a Solo 401k. Specifically, $19,500 if under age 50 and an additional $6,500 if age 50 or older. A SEP IRA does not allow for Roth Contributions. Visit Roth Solo 401k to learn more.

Solo 401k allows for Participant Loan (borrow from Solo 401k)

If you qualify for a Solo 401k, you may take a loan from your Solo 401k without having to pay distribution taxes or penalties. The maximum Solo 401k Loan amount is 50% of the participant’s solo 401k balance not to exceed $50,000.  Like all types of IRA accounts, the IRS rules do not permit loans to be taken from a SEP IRA.  Visit Solo 401k Loan to learn more.

You can serve as Trustee of your own Solo 401k

The rules permit the business owner to Trustee his or her Solo 401k assets, meaning that you don’t have to use the services of a custodian to hold/safe keep the Solo 401k investments.  As a result, holding and investment processing fees are greatly reduced or completely eliminated, and processing times greatly reduced since you don’t have to submit investment processing directions to the custodian. Conversely, a SEP IRA requires an IRA provider to maintain the paperwork and bookkeeping of the SEP IRA account.

Solo 401k may not be subject to annual reporting

A SEP IRA is subject to annual reporting (Form 5498) regardless of account value, whereas a Solo 401k may not be subject to annual reporting.  Solo 401k only requires filing of Form 5500 EZ once the total account value exceeds $250,000 and when you terminate the Solo 401k.  Visit Solo 401k Annual Reporting to learn more.

Establishing a SEP IRA- Three options

1. Use the approved IRS version of the plan document—the Form 5305-SEP, Simplified Employee Pension-Individual Retirement Accounts Contribution Agreement.
2. Offer a prototype SEP plan.
3. Use an individually designed SEP plan.

Form 5305 for SEP IRA

IRS Form 5305-SEP is an IRS model document, written and approved by the IRS, that employers may use to establish their SEP plans. Employers that use the Form 5305-SEP must maintain the plan on a calendar-year basis.

  • The Form 5305-SEP cannot be used if the self-employed business also sponsors another qualified plan such as a solo 401k plan.
  • Instead, it would need to use a prototype SEP IRA document which is often provided by the SEP IRA custodian.
  • This is a SEP IRA rule not a 401k plan rule.
  • See page 5 of IRS Publication 560  and here is the snippet.

Prototype SEP IRA

  • A prototype plan is a specially designed and drafted plan document, which should be submitted to the IRS for approval with Form 5306-A, Application for Approval of Prototype Simplified Employee Pension (SEP).
  • The IRA custodian that offers SEP IRAs would also offer a Prototype SEP IR document.

Individually designed SEP IRA

Only the employer on whose behalf the plan document was submitted and approved by the IRS may use this document. However, a much more cost-effective prototype SEP document would likely provide all the desired benefits.

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About George Blower

I have the privilege of educating our clients about our products and services so that they can make informed and confident decisions about their financial future. Prior to joining My Solo 401k Financial, I served as the general counsel for a subsidiary of a Fortune 500 financial services company. Learn more about George Blower and My Solo 401k Financial >>

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