SEP IRA vs. Solo 401(k)?

Transcript

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If you're watching this, odds are you're self-employed, or you get paid as if you were self-employed, meaning you work for a company but get paid on a 1099. In the IRS's eyes, that makes you a business owner. Nobody's taking taxes out of your check or signing you up for the company 401(k). You usually don't get those benefits. The money hits your account, and everything after that is on you. As far as the IRS is concerned, you're running a business, even if it's a business of one.

When you're self-employed, you're technically two people at once. You're the business, and you're also the person the business pays. I know that sounds odd, especially if you're paid on a 1099 but contracted by a company. Still, you're the boss and the employee.

Your day probably doesn't feel like that. You do the work, money shows up in your account, and that's the end of it. But the IRS treats that same money as two steps. First, your business earns it. Call that revenue. Then your business pays you. That's your income.

They split you in two mostly because of taxes. At a normal W-2 job, your employer pays half of your Social Security and Medicare and you pay the other half, and you probably don't notice because it happens behind the scenes. When you're self-employed, there's nobody to pay the other half, so you pay both halves yourself on top of your income tax. That's called self-employment tax.

Because you're the employer and the employee, this also shows up in retirement accounts. Anybody with earned income can open a traditional IRA or a Roth IRA. But as a business, as an employer, you can set up other retirement accounts that an individual can't. For a business of one, two types come up most: the SEP IRA and the solo 401(k). Let's break them down together.

The SEP IRA: only the employer side gets a turn

The SEP IRA only lets the employer side put in money. Your business can contribute a percentage of what you earn, but the employee side doesn't get a turn. A solo 401(k) lets both sides in. So at a certain income level, you can put more into a solo 401(k) than a SEP IRA, because the solo 401(k) has both doors open.

A $300,000 example

Say you're a consultant netting $300,000 a year on your own. In a SEP, the boss side can put away about $57,000. When you do the calculation, that's the maximum allowed in the SEP IRA.

Now say you had a solo 401(k) instead. The employer side of you can put in that same $57,000. But a workplace retirement plan can take up to $72,000, and in a solo 401(k) the employee bucket fills in the rest. That gets you all the way to the $72,000 limit, which is the most anyone under 50 can put into one of these plans. That's a lot different from the maximum for a traditional IRA or a Roth IRA.

That's about $15,000 more going in every year from the same income, and that's for one person. If your spouse works in the business and gets paid, they can be in the same plan with both buckets of their own.

Once you're earning more than $300,000, both plans eventually hit the same limit. So for high earners, the bigger difference is how each plan fits with the rest of your accounts, starting with your personal Roth IRA.

Why a SEP gets in the way of the backdoor Roth

Many of the people we work with make too much money to put money directly into a Roth IRA, so we use a strategy called the backdoor Roth. Money goes into a traditional IRA, and a few days later we convert it to a Roth IRA.

When you do a conversion, the IRS looks at all the pre-tax money you have in IRAs, and that includes SEP IRA accounts. So a big SEP balance messes up backdoor Roth conversions. I won't get into the nitty-gritty, but it can be a pebble in your shoe, especially when we're not trying to tip Uncle Sam.

A solo 401(k), or any 401(k), doesn't count. With a solo 401(k), the backdoor strategy stays clean, and you can usually roll an old SEP or traditional IRA into it by the end of the year to clear the way. On top of that, the employee bucket can go in as Roth no matter how much you earn. That's a great way for high earners to get money into a Roth account.

Adding a cash balance plan

This is where I think the solo 401(k) can really shine. Remember that $72,000 number? If your income is high and steady, especially in your late 40s and 50s, we can add what's called a cash balance plan that sits on top of your solo 401(k) to shelter more of your income from taxes.

It's a type of pension plan that we include in your workplace retirement plan structure, and depending on your age and income, it can take what you put away from around $72,000 to over $300,000 a year. Think about that. Big difference.

The reason to put that much in is taxes. That money comes off your income at your top bracket. Remember, this is mainly for high earners, so they're getting taxed federally at 35% or 37%, and that doesn't include state. Yes, you'll pay tax on these dollars in retirement, but hopefully at a much lower rate.

It does come with an actuary and a commitment to fund it for several years, so this probably isn't a strategy you can implement on your own. Our workplace retirement team works alongside the actuary, a TPA, and your CPA to make sure it's done correctly. Want a quick gut check first? Try our cash balance plan fit check.

Side by side

The SEP still makes sense in a few spots, but for a high earner working on their own, the solo 401(k) usually checks more of the boxes.

Setting up a solo 401(k) is also much easier these days. People hear "401(k)" and picture a third-party administrator, a TPA, charging a yearly fee to run a plan with one person in it. So they say, "Eh, I'll do a SEP IRA."

TPAs still have an important seat at the table, especially once you add a cash balance plan or hire employees. But a lot of owner-only solo 401(k)s don't need one. Austin and Joe, our workplace retirement specialists, help with the plan paperwork, and then we set it up at our custodian, Altruist. There's no separate administrator fee on top of what you're already paying us.

The one thing to know going in: a solo 401(k) is for business owners and their spouses only. Full stop. Once you have employees, it's a different conversation.

Setting one up

Setting one up with us is pretty low-key. We handle everything and loop in your CPA. If you want it in place for this year, we need to get it set up sooner rather than later, normally by mid-November, so everything is signed and funded before December 31.

If you want help figuring out which setup makes sense for you, give us a shout. Until next time.

Common questions

What is the solo 401(k) contribution limit for 2026?

The combined employee and employer limit is $72,000 for 2026. The employee deferral portion is up to $24,500 of that. If you're 50 or older you can add an $8,000 catch-up on top, or $11,250 if you're 60 to 63.

How much can I put in a SEP IRA in 2026?

Your business can contribute up to 25% of compensation, capped at $72,000. For a sole proprietor, the math works out to roughly 20% of net self-employment earnings after the deduction for half of self-employment tax, which is why $300,000 of net income lands around $57,000.

Does a SEP IRA affect a backdoor Roth conversion?

Yes. When you convert, the IRS adds up the pre-tax balances in all your traditional, SEP and SIMPLE IRAs as of December 31 of that year, and taxes the conversion in proportion. Money in a 401(k), including a solo 401(k), is left out of that math.

Can I make Roth contributions to a solo 401(k)?

Yes, if the plan allows it. The employee deferral can go in as Roth regardless of income, which gives high earners a direct route to Roth money that a Roth IRA's income limits would block.

Hosted byNick GeorgeCFP®, ChFC®, CLU®, IWA™FounderView bio →

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