Solo 401(k) vs. SEP IRA: Choosing the right retirement plan for your business

If you're self-employed or run a small business, choosing the right retirement plan can be a game changer for your financial future. Two popular options—solo 401(k)s and SEP individual retirement accounts (IRA)s—offer important tax advantages. Both options provide powerful retirement savings potential, but which one will help you maximize your financial growth?

Whether you want to maximize your savings or keep things simple, understanding the features of a solo 401(k) vs. a SEP IRA can help you find the right savings vehicle for your needs.

At a high level, a solo 401(k) is a retirement savings plan designed specifically for self-employed individuals or small business owners with no employees other than a spouse. These tax-advantaged accounts work much like 401(k)s offered by larger companies, but they're designed specifically for sole proprietors, freelancers and independent consultants. And they're ideal for those who want to save aggressively for retirement.

A simplified employee pension individual retirement account, or SEP IRA, is a retirement savings plan for small business owners, including those who have employees. Compared to a solo 401(k), these tax-advantaged accounts are often easier to set up and are available to more entrepreneurs. They're ideal for those who value simplicity and prefer to make employer-only contributions.

It can, although there's not always a clear-cut answer on which is best for each age group, since you can start a business at any age. One consideration, though, is how much time you have ahead of you. For instance, if you recently launched your business as a one-person operation and plan to develop your business into something much bigger in the years ahead, a SEP IRA might make things easier. That's because you can continue to contribute to your SEP IRA even as you add employees. You won't be able to do that with a solo 401(k) unless the only employee you add is your spouse.

Another consideration is that if you're a younger entrepreneur, contributing to a Roth retirement plan in particular can be advantageous. Your after-tax contributions give you the prospect of tax-free withdrawals in retirement—when you may be in a much higher tax bracket than you are now.

Age, therefore, plays a role, but it depends on your circumstances. Think through the pros and cons, and choose a plan that's best for you now and in future years.

If you have a solo 401(k) and you're no longer self-employed, you won't be eligible to make new contributions. However, the money you already put into the 401(k) will stay in your account. You can continue to change your investment choices or withdraw the funds in retirement as you otherwise would. You can also roll over your 401(k) assets into a separate retirement account, like your new employer's 401(k) plan or an IRA. Depending on the amount of money you have in the account, you may need to file one last IRS Form 5500-EZ if you decide to close out the solo 401(k).

It's a similar situation if you have a SEP IRA and no longer receive business income. Your contributions will have to stop, but you'll retain control over the funds you already have in the account. If you want to consolidate your retirement assets and simplify your financial picture, you can roll over the account into a traditional IRA.

Both solo 401(k)s and SEP IRAs can be effective self-employed retirement solutions. If you don't have employees, a self-employed 401(k) may give you an edge if you want to maximize your contributions and have a bit more flexibility.

While employers can theoretically contribute up to $69,000 a year with a SEP IRA, the fact that you're maxed out at 25% of income means that most middle-income entrepreneurs won't be able to put in that much. Compare that to solo 401(k)s, where you can invest 25% of your income as an employer plus your allowance of $23,000 per year as an employee. You can also kick in an extra $7,500 annually if you're at least 50 years old.

SEP IRAs function like traditional IRAs, where you make pre-tax contributions and pay income taxes only when you pull out money in retirement. That works great if you think you're in your peak earning years and want that upfront tax benefit. However, there are situations where having a Roth/tax-free retirement account is the better option, such as when you expect to be in a higher tax bracket in retirement than you are now, in which case, you may want to give a Roth solo 401(k) more consideration.

You can borrow from your solo 401(k) prior to retirement, giving you more financial flexibility than SEP IRAs, which do not share this feature. You can borrow up to $50,000 or 50% of your account balance, whichever is less.

Except for certain cases, such as buying a primary residence, you need to pay back the loan with interest within five years. Otherwise, the loan amount may qualify as an early withdrawal, which can trigger income taxes and a 10% early withdrawal penalty.

While solo 401(k)s may have advantages when it comes to higher contribution limits, you can't establish one if you're a small business owner who employs more people than just yourself and your spouse. Even if you're eligible for a solo 401(k), a SEP IRA can be an attractive alternative if you want to focus on growing your business rather than handling retirement plan paperwork.

Any small business owner, with or without employees, can open a SEP IRA. That makes these retirement plans a more viable option than a solo 401(k) for many entrepreneurs. Plus, all of your staff will be able to get the same contribution percentage, potentially making it easier to manage for everyone.

SEP IRAs also have the advantage in terms of administrative requirements since they have minimal paperwork. While solo 401(k)s are usually much easier to maintain than the 401(k)s used by larger companies, they still require filing an IRS Form 5500-EZ each year if your total assets exceed $250,000.

Many brokerage firms and mutual fund companies offer solo 401(k) plans, although their investment choices, fees and account minimums can vary. Your first step is to acquire an Employer Identification Number (EIN) from the IRS if you don't already have one. Most financial institutions will provide step-by-step instructions on how to establish the plan through their website.

SEP IRAs simply involve filling out the brokerage or fund company's application, which you can typically do online. As the employer, you'll also need to complete IRS Form 5305-SEP, which is a formal agreement between you and any employees you may have. Once those steps are completed, you can choose your investment options and start funding your account.

While the solo 401(k) and SEP IRA are popular retirement plans for self-employed individuals, there are other options. The SIMPLE IRA, for example, is available to small businesses with up to 100 employees. It's easier to set up than a typical 401(k) and allows both employer and employee contributions. However, the SIMPLE IRA contribution limit is lower than that of both solo 401(k)s and SEP IRAs.

If you're a high earner, you may also consider a defined benefit plan—also known as a cash balance pension plan—which may allow you to contribute more than either a solo 401(k) or SEP IRA. Your exact contribution limit is based on your age, expected rate of return, investment choices and other factors. The downside is that defined benefit plans are more expensive and cumbersome to operate.

As a self-employed person, you have a unique set of options for building your retirement assets, which means you can select a retirement savings plan that caters to your needs. A Thrivent financial advisor can help you evaluate your employment retirement savings strategy and give you confidence about your financial security today and into the future.