This post provides a high-level overview of each type along with an illustration of how they differ at differing levels of income. A complete explanation of how the calculations are done is beyond the scope of this article but we do illustrate them below. Note that for all retirement savings accounts, there is a maximum 2024 compensation limit of $345,000 and total contribution limit of $69,000 from all sources (with the exception of 401(k)s and 403(b)s which allow participants aged 50+ to add an additional $7,500). This limit is known as the “415(c) limit.”

SEP IRAs (Simplified Employee Pension)

A Simplified Employee Pension Individual Retirement Account (SEP IRA) is a type of IRA that is set up by the employer (you) to set aside money in a retirement account for the employee (also you). They are unique in that only the “employer” may contribute instead of an employer/employee combination. They are easy to set up and manage, and the employer can contribute 25% of compensation (net of self-employment taxes). However, it’s important to note that to reach the maximum allowable 2024 contribution, the employer must have net earnings of more than $300,000. Contributions into a SEP IRA is pre-tax and into a Roth SEP IRA is after-tax, which was introduced in 2023 under The SECURE Act 2.0.

Solo 401(k)s

A Solo 401(k) is a type of individual 401(k) for single-person businesses (or those with only a spouse on the payroll).  These accounts offer more and higher contribution options. A key distinction here, when compared to the SEP IRA, is the ability to contribute as both “employer” and “employee” at amounts up to 100% of compensation (within the 415(c) limit). Solo 401(k)s also allow Roth contributions, letting you save after-tax dollars that grow tax-free. However, Solo 401(k)s typically involve a more complex and potentially expensive setup and have some ongoing administrative tasks.

One enticing benefit of Solo 401(k)s is a potential tax credit for startup and administration costs. The SECURE Act allows you to claim a credit of up to $500 per year (for a maximum of three years) for including an automatic enrollment feature in your Solo 401(k).

It’s important to note that Solo 401(k)s may have additional filing requirements compared to SEP IRAs. If the total assets in your Solo 401(k) exceed $250,000, you need to file an annual Form 5500-EZ with the IRS. This form provides information about your plan’s participants and finances.

Illustrated Comparison: SEP IRA vs Solo 401(k)

An Illustration is helpful to see which type of account is best for your business based on your income as well as your ability to contribute that income to a retirement account.

Assume your business earns $100,000 in 2024 and you want to maximize the amount you save in your retirement account.  Note if you are 50+ only the solo 401(k) allows for a catch-up contribution. In addition, only an employer can contribute to a SEP; each partner or member of an LLC taxed as a partnership is an employee of the partnership.[1]

The Bottom Line

Ultimately, the best choice depends on your individual circumstances. But it is especially important to realize the distinction between the employer/employee relationship on these types of plans. SEP IRAs are ideal for those seeking simplicity and who don’t need the extra contribution options. Solo 401(k)s offer greater flexibility and potential for larger contributions but come with added complexity and potential filing requirements. Consulting with your Envest advisor can help you determine which option best suits your retirement savings goals.

[1] https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-seps