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

Last Updated November 19, 2024 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 2024, she will be able to contribute $55,500 for 2024 consisting of a $23,000 employee deferral, a $7,500 catch-up since she is age 5o or older in 2024, and a $25,000 employer profit sharing contribution.  On the other hand, if Karen established a SEP IRA, she would only be able to contribute $25,000 for 2024 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 2024 the self-employed business owner may make up to $30,500 in Roth contributions to a Solo 401k. Specifically, $23,000 if under age 50 and an additional $7,500 if age 50 or older. A SEP IRA does not allow for  catch-up contributions, and while  the SEP IRA allows for employer Roth Contributions up to the 25% of the W-2 wages if the business is taxes as an S-corp., special IRS Form 1099-R reporting would apply such as the following: Roth salary deferral contributions are included in the participant’s gross income in the tax year in which the participant would have otherwise received the contribution as compensation. The employer must report these contributions on Form W-2, Wage and Tax Statement. Employer Roth matching and Roth nonelective contributions are includable in the participant’s gross income in the year that the contribution is actually made to the Roth IRA, regardless of whether the contribution is treated as made for the prior tax year. Employers must report these contributions on Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit Sharing Plans, IRAs, Insurance Contracts, etc. 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 Credit of $1,500 A solo 401k qualifies for the $1,500 auto contribution tax credit whereas the SEP IRA does not. 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 IRA 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.