The Benefits of SEP IRA and Solo 401(k) for Self-Employed Individuals: Why the Solo 401(k) Might Be Your Best Choice

For self-employed individuals or those with W2 income who also earn 1099 income, planning for retirement can seem daunting. Without an employer-sponsored retirement plan, it’s essential to find the best tools to save efficiently. Two popular retirement plans for self-employed individuals are the Simplified Employee Pension (SEP) IRA and the Solo 401(k). Both offer significant benefits, but the Solo 401(k) often stands out, especially with the option for mega backdoor Roth contributions. This article will explore the advantages of each plan and explain why the Solo 401(k) might be the better choice for maximizing your retirement savings.

 

Benefits of SEP IRA

  1. High Contribution Limits: The SEP IRA allows contributions of up to 25% of your net earnings from self-employment, up to a maximum of $69,000 for 2024. This can enable substantial retirement savings.
  2. Simplicity and Ease of Setup: Setting up a SEP IRA is straightforward and involves minimal paperwork. It’s an attractive option for self-employed individuals who prefer a simple, hassle-free retirement plan.
  3. Flexibility with Contributions: Contributions to a SEP IRA are not required every year. This flexibility is beneficial for those with variable incomes, as you can decide how much to contribute based on your financial situation each year.
  4. Tax Advantages: Contributions to a SEP IRA are tax-deductible, reducing your taxable income for the year. This can result in significant tax savings.

 

Benefits of Solo 401(k)

  1. Higher Contribution Limits: The Solo 401(k) has the same overall contribution limit as the SEP IRA ($69,000 for 2024), but it allows for more substantial contributions at lower income levels. This is because you can contribute both as an employer and an employee. As an employee, you can contribute up to $23,000 (or $30,500 if you’re over 50), and as an employer, you can contribute up to 25% of your net earnings.
  2. Catch-Up Contributions: If you’re 50 or older, the Solo 401(k) allows for an additional $7,500 in catch-up contributions, which can significantly boost your retirement savings.
  3. Loan Provision: The Solo 401(k) allows you to take loans from your retirement account, providing flexibility in case you need access to funds. You can borrow up to 50% of your account balance, up to a maximum of $50,000.
  4. Roth Option: The Solo 401(k) can include a Roth component, allowing you to make after-tax contributions and enjoy tax-free withdrawals in retirement. 
  5. Mega Backdoor Roth Contributions: One of the most compelling reasons to choose a Solo 401(k) is the option for mega backdoor Roth contributions. This allows you to contribute up to $66,000 (or $73,500 if you’re over 50) in after-tax contributions and then convert them to a Roth 401(k) or Roth IRA. This strategy can significantly boost your tax-free retirement savings. This feature is not available with all Solo 401k plans so be sure to discuss with a qualified financial professional.

 

Why the Solo 401(k) Might Be the Better Option

The flexibility and additional features of the Solo 401(k) make it a more powerful retirement savings tool for many self-employed individuals. While both plans offer high contribution limits and tax advantages, the Solo 401(k) provides several key benefits that the SEP IRA does not:

  1. Higher Contributions at Lower Income Levels: The ability to contribute as both an employer and an employee allows for higher contributions at lower income levels compared to the SEP IRA.
  2. Catch-Up Contributions: The additional $7,500 catch-up contribution for those 50 and older can significantly enhance retirement savings.
  3. Roth and Mega Backdoor Roth Options: The Roth component and the ability to make mega backdoor Roth contributions provide unique opportunities for tax-free growth, which can be a game-changer for long-term retirement planning.
  4. Loan Provision: The option to take a loan from your Solo 401(k) offers financial flexibility not available with a SEP IRA.
  5. Auto Enrollment Tax Credits: While both plans are eligible for start-up tax credits, the Solo 401k also offers the Auto Enrollment Tax Credit which can be worth $1500 over 3 years.

 

Conclusion

Both the SEP IRA and the Solo 401(k) offer excellent retirement savings opportunities for self-employed individuals. However, the Solo 401(k) stands out due to its higher contribution potential at lower income levels, catch-up contributions, Roth options, and the powerful mega backdoor Roth strategy. If you are a self-employed individual looking to maximize your retirement savings, the Solo 401(k) is likely the superior choice.

By leveraging the unique advantages of the Solo 401(k), you can build a robust retirement portfolio that provides both flexibility and significant tax benefits. Whether you’re just starting your self-employment journey or looking to optimize your existing retirement strategy, considering a Solo 401(k) could be one of the best financial decisions you make.

At VetWorth, we use the services of MySolo401k to set up the plan documents to allow for tax credits and the mega backdoor Roth option. You can also open Solo 401ks at other custodians (Schwab, Fidelity) but they may be limited in their features.

 

 

Andrew Langdon is a CERTIFIED FINANCIAL PLANNER™, CERTIFIED Student Loan Professional™ and the founder of VetWorth, a fiduciary fee-only financial planning firm dedicated to serving the unique needs of veterinarians and their families.

Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Andrew Langdon, and all rights are reserved. Read the full Disclaimer.

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