For the nation’s millions of self-employed workers, freelancers, and small business owners, choosing the right retirement plan is a critical financial decision that directly impacts long-term wealth. The two leading options, the Simplified Employee Pension (SEP) IRA and the Solo 401(k), both offer the ability to save significantly more than a traditional IRA, but they cater to different needs and strategies. The Solo 401(k) generally allows for higher contributions at most income levels and offers more features like a Roth option and loan provisions, while the SEP IRA provides unparalleled simplicity in setup and administration, making the choice a crucial trade-off between power and ease.
The Challenge of Saving for the Self-Employed
When you work for yourself, you are the CEO, the employee, and the entire HR department. This means the responsibility for funding your retirement rests solely on your shoulders. Without access to a traditional employer-sponsored 401(k) with its convenient automatic deductions and potential company match, you must be proactive.
This is where specialized retirement plans come into play. While anyone can contribute to a Traditional or Roth IRA, the annual contribution limits are relatively low. Plans like the SEP IRA and Solo 401(k) were designed specifically for the self-employed, allowing for tax-advantaged contributions that are multiples higher, dramatically accelerating your path to financial independence.
Understanding the SEP IRA
The SEP IRA, or Simplified Employee Pension plan, is often favored for its straightforward nature. It is a retirement plan that allows an employer—in this case, you—to make tax-deductible contributions on behalf of eligible employees, including yourself.
How SEP IRA Contributions Work
A key feature of the SEP IRA is that only the employer makes contributions. As a self-employed individual, you act as your own employer. The amount you can contribute is based on a percentage of your compensation.
For 2024, you can contribute up to 25% of your net adjusted self-employment income, not to exceed a maximum of $69,000. Calculating “net adjusted self-employment income” involves taking your gross self-employment earnings and subtracting one-half of your self-employment taxes. This calculation effectively makes the contribution limit closer to 20% of your gross income.
For example, if you are a freelance designer who earned $120,000 in net self-employment income, you could contribute approximately $22,300 to your SEP IRA for the year. This contribution is tax-deductible, lowering your current-year taxable income.
The Pros of a SEP IRA
The primary advantage of the SEP IRA is its simplicity. Opening an account at a major brokerage is exceptionally easy and often takes just a few minutes online. There is minimal ongoing paperwork required.
Contribution flexibility is another major benefit. If your business has a lean year, you are not required to make a contribution. In profitable years, you can contribute the maximum allowed. Furthermore, you can establish and fund a SEP IRA for the previous tax year up until the tax filing deadline, including extensions, giving you more time to decide and act.
The Cons of a SEP IRA
The SEP IRA’s biggest drawback is its lack of a Roth component. All contributions are pre-tax, meaning you get a tax deduction now, but all withdrawals in retirement will be taxed as ordinary income. You cannot make post-tax Roth contributions.
Additionally, SEP IRAs do not permit loans. You cannot borrow against your account balance, which removes a potential source of liquidity in an emergency. Finally, if you have employees, the plan can become expensive. You must contribute the same percentage of compensation for every eligible employee as you do for yourself, which can be a significant business expense.
Understanding the Solo 401(k)
The Solo 401(k), also known as an Individual 401(k), is a more powerful and feature-rich plan designed exclusively for business owners with no employees, other than a spouse. If you are a freelancer, contractor, or consultant, you are eligible.
The Dual-Contribution Advantage
The most significant advantage of the Solo 401(k) is that it allows you to contribute in two distinct roles: as the “employee” and as the “employer.” This dual structure often allows you to contribute more money than you could with a SEP IRA, especially at lower and moderate income levels.
As the Employee: For 2024, you can contribute up to 100% of your compensation, with a maximum contribution of $23,000. If you are age 50 or older, you can add a “catch-up” contribution of $7,500, for a total of $30,500.
As the Employer: Just like the SEP IRA, you can also make a profit-sharing contribution of up to 25% of your net adjusted self-employment income.
The total combined contributions from both the employee and employer cannot exceed $69,000 for 2024 (or $76,500 if you are age 50 or older).
Solo 401(k) Contribution Example
Let’s revisit our freelance designer who earned $120,000. With a Solo 401(k), they could make a $23,000 employee contribution plus an employer contribution of approximately $22,300 (the same 20% of gross). This totals $45,300 in contributions, significantly more than the $22,300 allowed with the SEP IRA at the same income level.
The Pros of a Solo 401(k)
Beyond higher potential contributions, the Solo 401(k) offers a Roth option for the employee portion of your savings. This means you can contribute up to $23,000 (or $30,500 if 50+) on a post-tax basis, allowing for tax-free growth and tax-free withdrawals in retirement—a powerful tool for tax diversification.
Another key feature is the ability to take a loan from your account. Most plans allow you to borrow up to 50% of the vested account balance, capped at $50,000. For a business owner, this can be a valuable lifeline to cover short-term expenses without derailing retirement savings.
The Cons of a Solo 401(k)
The power of the Solo 401(k) comes with added complexity. The setup process is more involved than a SEP IRA, and the plan documents must be established by December 31 of the tax year, even though you have until the tax deadline to fund it.
Administration is also more demanding. Once your plan’s assets exceed $250,000, you are generally required to file an annual Form 5500-EZ with the IRS. Most importantly, the moment you hire a non-spouse employee, you are no longer eligible for the Solo 401(k) and must transition to a different type of plan.
SEP IRA vs. Solo 401(k): A Direct Comparison
Choosing the right plan comes down to your specific business structure, income, and financial goals. Here is a head-to-head breakdown of the key features.
Best for Maximum Contributions
The Solo 401(k) is the winner for most people. The ability to make a large, dollar-for-dollar employee contribution on top of the employer profit-sharing portion means you can save more money faster, particularly if your income is less than approximately $275,000. Above that income level, the 25% employer contribution alone is enough to hit the maximum limit, making the plans equal on this front.
Best for Simplicity and Ease of Use
The SEP IRA is the undisputed champion of simplicity. If you want a “set it and forget it” plan with minimal paperwork and the flexibility to set it up after the year has already ended, the SEP IRA is the ideal choice. It is perfect for those who prioritize ease over advanced features.
Best for Tax Flexibility (Roth Option)
The Solo 401(k) is the only option that offers a Roth component. The ability to make post-tax contributions is a massive strategic advantage for long-term tax planning. If you believe your tax rate will be higher in retirement than it is today, the Roth Solo 401(k) is an invaluable tool.
Best for Access to Capital (Loans)
Again, the Solo 401(k) wins. The plan’s loan provision provides a safety net that the SEP IRA simply cannot offer. For a self-employed individual whose income can be unpredictable, having access to this liquidity without penalty can be a game-changer.
What If I Have a Day Job?
This is a common scenario for side-hustlers. It is important to know that the employee contribution limit ($23,000 in 2024) is per person, not per plan. If you max out the 401(k) at your day job, you cannot make an additional employee contribution to a Solo 401(k).
However, you can still make the employer contribution to either a SEP IRA or a Solo 401(k) based on your self-employment income. This makes both plans excellent vehicles for supplemental retirement savings, even if you have a primary job.
Making the Right Choice for Your Future
Ultimately, the decision between a SEP IRA and a Solo 401(k) is a personal one. If you are just starting out, value simplicity above all, or have unpredictable income streams, the SEP IRA is a fantastic and easy-to-manage choice.
However, if you are serious about aggressively maximizing your retirement savings, want the tax diversification of a Roth account, and value the security of a loan provision, the extra administrative effort of the Solo 401(k) is well worth it. For most dedicated freelancers and consultants, the Solo 401(k) offers a superior set of tools for building a secure retirement.
Regardless of which plan you choose, the most important step is to start. By taking advantage of these powerful retirement accounts, you are taking control of your financial future and ensuring that the hard work you put into your business today will reward you for a lifetime.
