The simple answer is yes and no, you may contribute to a Solo 401(k) and SEP IRA in the same year. It all depends on the forms you use, which we’ll explain later. Your small business can maintain both plans, but there’s really no advantage to utilizing both. Generally, unless you have full-time employees, the Solo 401(k) plan is the superior option. Once you hire employees for your business (other than a spouse or partner), you can no longer have a Solo 401(k). These plans are for owner-only businesses and the self-employed. The SEP IRA remains a solid option for expanding small businesses.
- If you are self-employed, you need to decide on the best retirement plan for yourself.
- You can have both a SEP IRA and Solo 401(k) plan, but should you?
- If you have no full-time employees, the Solo 401(k) is the best option for the self-emplpyed.
What is a Solo 401(k)?
A Solo 401(k) is a retirement plan specifically designed for the self-employed. You don’t need your own business to open one. In fact, many people who have regular jobs can have one. The key is that you need some sort of self-employed income. This will generally come from a side job, oftentimes “gig” work. This may include driving for a ride-share company, hiring speaking engagements, or an Etsy store.
Of course, if you have your own business, you can get the most advantage of the Solo 401(k). The caveat is that you cannot have any full-time employees, aside from your spouse or a business partner. A full-time employee is someone who works more than 1,000 hours for you during the year. Of course, temp workers and seasonal employees can be hired, so long as they don’t exceed the hour threshold.
One of the biggest advantages of the Solo 401(k) is the high annual contribution limits. For 2024, contribution limits to a Solo 401(k) plan are as follows:
- Employee Deferral – $23,000
- Employer Contribution – $46,000
- Catch-up Contribution – $7,500
- Total Contribution Limit – $69,000 or $76,500 for those aged 50 and older
Read More: Solo 401(k) 2024 Contribution Limits
What is a SEP IRA?
A SEP IRA, known as a Simplified Employee Pension, is another option for the self-employed. It’s especially beneficial for small business owners who have full-time employees. There are two major differences between a Solo 401(k) and SEP IRA. First, there is “no catch-up” contribution. There is no increase in the amount you may contribute at age 50. Secondly, there isn’t an employee deferral. All contributions are based on a percentage of your annual income. Generally, it’s 20% for business owners and 25% for self-employment work. Therefore, it’s harder to max out your contributions to the max of $58,000.
If you have other employees, you must contribute on their behalf the same percentage you take yourself. However, you do not have to make contributions every year. During a down year, you may skip saving altogether. A SEP is a very cost-effective way to offer a retirement plan for small business owners. On the other hand, it doesn’t really make much sense for an owner-only business.
Learn More: How to Correctly Diversify Your Retirement Account
When Can You NOT Do Both?
If you use a financial institution or custodian to set up your SEP IRA, you need to be aware of what form they use. If they use the standard IRS Form 5305, then you cannot also set up a Solo 401(k). This form is provided by the IRS, so it is unusual that you are limited in your options when you use it.
However, there is a workaround. You simply need to set up the SEP IRA not using the From 5305. You can essentially take the basics of the form and tweak it for your use. Of course, your financial institution must accept the form in order to be eligible. You can work with an attorney or financial planner to help design the form. But again, if you have zero full-time employees, it’s probably not worth the hassle anyway!
Solo 401(k) vs. SEP IRA
As detailed above, the Solo 401(k) is the far superior option for the self-employed. It is only when you hire non-spouse or non-owner full-time employees that a SEP IRA makes sense. Contributing to both plans makes little sense. The only time it may be useful is if you have both a small business and other self-employed income. A SEP IRA can be set up for your business where only that income will be contributed to the plan. If you have a side job, apart from the business, you can set up a Solo 401(k) for your own use.
Example
Let’s say Phil is a part owner in a small cafe. He has two partners, and each owns 33% of the business. He starts a SEP IRA for his business and decides to contribute 10% to the plan. Generally, all partners would contribute the same amount, assuming they earn compensation from the business. The business earns $200,000 during the year. Therefore, he will contribute $20,000 to his SEP IRA (10% of $200,000).
Phil also works for DoorDash on the side and earns an extra $15,000 per year. He sets up a Solo 401(k), which allows him to contribute the entire amount into the plan. In total, Phil will save $35,000 towards retirement for the year.
During a tough financial year for the cafe, Joe may elect to not contribute anything to the SEP IRA. On the plus side, he may still elect to contribute funds to his Solo 401(k), provided he has other self-employed income.
Other Circumstances
Let’s say Phil was the sole owner of the cafe and had a few full-time employees. In this case, Phil would not be able to contribute to a Solo 401(k) unless he offered the same benefit to the employees of the cafe. This is known as a controlled group. Because he owns more than 80% of each business (the cafe and his DoorDash business), he cannot “stiff” the employees.
Essentially, if you are the sole owner of a business that has full-time employees, you cannot exclude them by opening up a separate retirement plan for yourself.
Self-Directing Your Solo 401(k) and SEP IRA
Lastly, we wanted to mention the benefits of self-directing your Solo 401(k) and SEP IRA plans. The benefits of opening your plan with IRA Financial is that you can have checkbook control of your funds. This allows you to make both traditional investments, in addition to alternative investments, such as real estate, precious metals and cryptocurrencies, like Bitcoin.
Further, with checkbook control, you never need to ask for permission to invest. A bank account is associated with your plan and can be used to make investments without a middleman. This allows you to make any investment you want in a timely matter. The checkbook control structure can be used with both a Solo 401(k) and SEP IRA.
Learn More:
How Do Self-Directed IRAs Work?
If you have any questions about either plan, please contact us to discuss. We can help decide if a Solo 401(k) or SEP IRA is right for you. In certain circumstances, you may want to contribute to both. As always, you should work with a financial advisor to come up with a financial plan that fits your needs.
