Solo 401(k) vs. SEP IRA: What's the Best Plan for Your Freelance Income?

Why do you need a retirement plan as a freelancer?

These plans provide big cushions after you retire, and they come with tax breaks that can save you a considerable amount of money when you do your taxes. You can even start contributing to them before your business is profitable.

Even better, the two best retirement plan options for freelancers allow far more generous contributions than traditional IRAs or employee-sponsored retirement plans: $66,000 for 2023, instead of $6,500 for an IRA or $22,500 for a 401(k).

These are the solo 401(k) and the SEP IRA.

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What is the solo 401(k)?

The Individual 401(k),also known as a Self Directed Solo 401(k), is just a traditional 401(k) plan for freelancers, independent contractors, sole proprietors, and small business owners. It’s the same as the employer-sponsored plans at bigger companies. 

Who can start a solo 401(k)?

Anyone who makes some money from self-employment (literally any amount counts) can set up a solo 401(k), as long as they don’t have any full-time employees.  You don’t need to have an LLC or a business license.

How much can you contribute per year?

As of 2023, the maximum amount you can contribute to a Solo 401(k) is $66,000. That includes both the amount you’re contributing as an employee, and the amount you’re contributing as your own employer.

As an employee

Your employee contribution, called an “employee salary deferral,” can total $22,500 in 2023, and this can be up to 100% of the net profits from your side hustle or business. That means that, if you earn less than $22,500, you’re free to put it all into a solo 401(k) and avoid paying taxes on it for the year.

If you’re 50 years old or older in 2023, you can also add an extra $7,500 a year, in what’s called in “catch-up contributions,” each year. 

As an employer

Your employer contribution is limited to 25% of your net income.

What is the SEP IRA?

A SEP IRA is a profit-sharing retirement plan for self-employed individuals. (SEP stands for “Simplified Employee Pension.”)

It's basically a traditional employee pension plan, which means it’s ideal for small businesses with employees. It’s also a great option for someone who has already reached the contribution limit on their day job’s 401(k). 

Who can start a SEP IRA?

To qualify for a SEP IRA, you have to:

• Be at least 21 years old
• Have earned at least $600 from self-employed work in the last year
• Have done the same self-employed work for three of the past five years 

How much can you contribute per year?

As of 2023, you can contribute 25% of your salary, up to $66,000. That’s a lot more than what you can contribute to traditional or Roth IRAs. That limit is $7,500 in 2023.

What tax breaks can you get with a solo 401(k) or SEP IRA?

Both types of accounts can help you reduce your tax bill, because the money you put in can be shielded from taxation. For example, if you earn $50,000 from freelancing and put $15,000 in a retirement account, your taxable income will only be $35,000.

To claim this tax deduction, you’ll report your contributions on line 16 of Schedule 1 of your Form 1040 tax return.

If you’re a freelancer or side hustler, file through Keeper, and we’ll make sure your retirement savings are helping you save at tax time. And while we’re at it, our software — designed specifically for self-employed people — will translate your business expenses into tax savings too.

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The more you put into your retirement account, the more you’ll save on taxes. For most people, solo 401(k)s offer better tax benefits than SEP IRAs, thanks to more flexibility in how you can contribute, plus a Roth option.

In addition, your contributions might also qualify for the Retirement Savings Contribution Credit, or Saver’s Credit, if your adjusted gross income is less than $36,500.

Tax benefits of a solo 401(k)

The Solo 401(k) generally offers more generous tax breaks because it can be funded from two different sources. As mentioned, these are:

• Up to 25% from your contribution as an employer
• Up to $22,500 from your contribution as an employee (with an additional $7,500 in catch-up contributions if you’re over 50)

The overall IRS limit for contribution is $66,000.

Plus, a solo 401(k) lets you make post-tax Roth contributions on the employee side — which means you won’t have to pay taxes on that money when you withdraw it.

Tax benefits of a SEP IRA

Unlike with a solo 401(k), you can only contribute to this account from the employer side. The SEP IRA contribution limit is 25% of your income, or $66,000. This limits how much you can contribute, unless your income is high enough.

Unlike solo 401(k)s, SEP IRAs don’t allow for Roth contributions. Since the funds you put in can only be pre-tax, you’ll pay taxes on them on the way out. 

Which retirement account has the best tax advantages?

In general, a solo 401(k) offers bigger tax breaks, since you can fund the account from two sources. 

For example, say that your side hustle brings in $50,000 a year. Your day job pays the bills, so you want to save as much of your freelance income as possible. Here’s how the two accounts compare:

• Solo 401(k): You can contribute $22,500 as an employee, plus 25% of your income, or $12,500. That brings your total contribution up to $35,000
• SEP IRA: You can only contribute the $12,500 from the employer side

Note that the employee-side contribution of $22,500 applies to all your 401(k) plans. So if you also have a 401(k) through your day job, your contribution to that account plus your solo 401(k) is capped at a combined $22,500.

Is a solo 401(k) or SEP IRA better for you?

Most freelancers will save more on their taxes with a 401(k). But ultimately, the best choice for any freelancer depends “on how much they are able to contribute, and how much time they have to dedicate to the management of the plan,“ said Houston-based CPA Thomas PM Perry.

In other words, let your personal priorities guide you. To help you figure those out, here are 10 possible scenarios where one plan is definitely a better choice than the other. See which ones describe your current situation best — that’s probably the better option for you:

You want to contribute as much as possible

Winner: Solo 401(k) 

There’s a reason these are such popular self-employed retirement plans: You get to contribute twice — once as your own employer, and once as your own employee. As mentioned, that means you can contribute more on the same income, leading to bigger tax deductions.

Plus, the solo 401(k) allows extra catch-up contributions if you’re over 50.

Your company has at least one full-time employee (other than your)

Winner: SEP IRA

You can’t create a solo 401(k) if you have any full-time employees (i.e. an employee who works more than 1,000 hours a year for you). That includes seasonal or temp workers who bill that much. 

The Solo 401(k) option will only cover you and your spouse, if applicable. So if your team is bigger (or you foresee that happening), an SEP is your best bet. 

You want to contribute the annual maximum amount all at once

Winner: Solo 401(k) 

As your own employee, you can immediately contribute the maximum annual amount from your salary to your plan every year — $20,500 or $27,000 with the catch-up contribution. 

Similarly, your employer can contribute to your in one lump sum or stagger the deposits over the year, as long as the contributions are made before the employer's tax return filing deadline (including extensions).

You want a Roth option

Winner: Solo 401(k) 

With a Roth account, your account’s earnings are tax-free, and you also won’t be taxed when you withdraw money as long as the account has been open for at least five years. A SEP IRA doesn’t have a Roth option, but a solo 401(k) does — one of the main reasons it’s so popular. 

Also, SEP IRA contributions are capped at 25% of your income. And because you might not know how much that is till the year is over, you can't exactly frontload your contributions.

You’d like to be able to take a loan in case of an emergency 

Winner: Solo 401(k)

Like all 401(k) plans, a solo 401(k) plan can be structured to:

• Allow for loans
• Accept rollovers from other retirement accounts
• Be rolled over into other accounts.
  

For greater flexibility, it can also be set up to allow for distributions in the case of hardship — meaning you can take out money early if there’s an emergency without paying any penalties. This isn’t possible with an SEP IRA, where early withdrawals might result in tax penalties. 

You have (or might hire) full-time employees

Winner: SEP IRA

A solo 401 (k) won’t grow with your business if you plan on adding employees. You’ll need a SEP IRA, which allows employers (including the self-employed) to make contributions to their employee’s retirement plans

Just remember that you can’t exclude any workers from the plan and you will have to contribute the same percentage of salary for all eligible employees — from yourself to your junior workers. 

You want to invest in real estate. Or maybe… Bitcoin?

Winner: Solo 401(k)

A Solo 401(k) allows you to invest in almost anything — even crypto —  without triggering a tax called the so-called “Unrelated Business Income Tax” (UBIT or UBTI for short). 

A SEP IRA, on the other hand, offers only traditional investment options like stocks and mutual funds. So if you’re interested in alternative or non-traditional investing, it isn’t the retirement plan for you.

You’re doing your taxes in February and need to reduce your tax burden from last year

Winner: SEP IRA

Solo 401(k) plans need to be opened by the end of the tax year (December 31, 2023, for example) to provide any tax benefits for that year (2023). So if you waited until after New Year's to look at your taxes, your only option is an SEP IRA, which can be opened to provide tax breaks for the prior year. 

Find yourself doing your taxes at the last minute and desperately wanting to reduce your liability? A SEP IRA account is the way to go.

You turned 50 years old (or older) during the current tax year

Winner: Solo 401(k)

If you — or your spouse — is age 50 or older, a Solo 401(k) allows “catch up contributions.” 

Originally designed to help those who started saving for retirement later in life, these allow you to contribute up to an extra $7,500 in 2023 (over the normal contribution maximum for your Solo 401(k). 

That brings the total possible contribution for a 50-plus freelancer up to $81,000.  And the catch-up contribution amount goes up to $10,000 in 2024. 

You don’t have time to manage anything complicated

Winner: SEP IRA 

Putting together any 401(k), including a solo 401(k), will take more time than an SEP. You’ll have a lot more paperwork and forms to fill out and possibly some setup and management fees. Plus, the IRS requires that you meet certain nondiscrimination requirements and carry out some fiduciary duties. 

An SEP is less complicated to maintain and has fewer administrative costs than a 401(k). So if your time is a precious commodity, an SEP IRA is the one for you. 

Can you have both a solo 401(k) and a SEP IRA? 

The short answer is yes — you can open both accounts. This can be helpful if, for example, you have employees and want a SEP IRA for them, but are also interested in the Roth option provided by a solo 401(k).

If you want to invest in both a 401(k) and a SEP IRA, you’ll have to meet eligibility requirements for both plans. (The same is true if you want to double up with or multiple 401(k)s, or invest in both an employer-sponsored 401(k) and a SEP IRA.)

There are a couple of other caveats for those with multiple retirement accounts. 

Opening both accounts with the same company

As mentioned, if the solo 401(k) and SEP IRA plans are offered by the same company, your combined contribution for both plans can’t exceed the annual contribution limit for the year. 

That means you’re capped at $66,000 for the year regardless. (If you have two separate businesses, though, you can contribute up to $66,000 for each of them.)

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Using IRS Form 5305

If you use a standard IRS Form 5305 to set up your SEP IRA, you can’t also set up a solo 401(k). 

Luckily there’s an easy fix: literally don’t use Form 5305. The IRS form isn’t required, and you can submit your own document.  Just make sure that your plan provider (meaning, probably your company) accepts the document. Otherwise, they’ll consider you ineligible. 

If you’re self-employed, retirement can seem very far away. Frankly, it’s hard for me to imagine not sitting at a computer trying to choose the right word to convey the right thought. And past financial emergencies have made me a little obsessed with having ready cash available. But then I did this calculation:

If I put $10,000 a year into a retirement plan at a 7% average real rate of return, I have twice as much money when I retire than if I just left it in my checking account. 

Let me repeat that: twice as much. No more counting change!

If that isn’t an argument for investing your self-employment money in a retirement plan, then I don’t know what is! 

Of course, every situation is unique. So to get the best tax advice about self-employment retirement plans, download the Keeper app to get help from a tax expert or contact Keeper at support@keepertax.com to get your questions answered today.