As a self-employed physician or owner of a medical practice with a handful of staff members, you may be exploring optimal retirement plans for your personal needs and the health of your business.
Two common options include Simplified Employee Pension (SEP) Individual Retirement Accounts (IRAs), and individual 401(k) plans, also known as solo 401(k)s.
But how do you decide which retirement plan works best for your situation?
Let’s start with a quick overview in the table below:
This article was submitted by Jorge Sanchez, M.D.
Solo 401(k) vs SEP IRA Summary
|Solo 401(K)||SEP IRA||Advantage|
|Eligibility||Business owners or self-employed individuals with no employees (except their spouse)||Business owners or self-employed individuals (with or without other employees)||SEP-IRA - more flexibility|
|Contribution Limits||The maximum combined employer and employee contribution is $66,000.|
The maximum employee contribution is $22,500.
The maximum employer contribution is $43,500.
You can contribute up to 20% of w-2 income or 25% of self-employment income, whichever is lower.
To contribute the maximum amount, you must earn an annual salary of $217,500.
$7,500 catchup contribution for people over 50 years old.
|Max total contribution of $66,000 or 25% of total compensation for 2023, whichever is less.|
To contribute the maximum amount, you must earn an annual salary of at least $264,000.
|Solo 401(k) - A solo 401(k) allows higher contributions if your earnings are less than $264,000.|
|Taxes on Contributions / Distributions||A solo 401(k) can be a traditional or a Roth plan. The taxes on the contribution and distributions depend on which type you choose.|
Traditional: Contributions are pre-tax and distributions are taxed.
Roth: Contributions are taxed and distributions are tax-free.
|A SEP-IRA can either be a traditional or a Roth plan. The taxes on the contribution and distributions depend on which type you choose.|
Traditional: Contributions are pre-tax and distributions are taxed.
Roth: Contributions are taxed and distributions are tax-free.
|Contribution Flexibility||Contributions can be made any time before you file your tax return’s due date, including an extension.||Contributions can be made any time before you file your tax return’s due date, including an extension.||Tie|
|Backdoor Roth||Solo 401(k) plans can be rolled over directly into a Backdoor Roth||If you have pre-tax funds in a SEP IRA, this can make Backdoor Roth conversions more complicated||Solo 401(k) - Allows for direct conversion to Backdoor Roth|
|Set-up / Admin||Requires EIN for account set-up.|
Once the plan’s assets reach $250,000, you must file Form 5500.
|Simple to create and cost-effective to maintain.|
Requires little to no administration.
No reporting requirements for employers.
|SEP-IRA - Easier set-up and lower administration expense|
What is a Solo 401(k)?
Most people are familiar with 401(k) plans through their employers, but 401(k)s are also available to self-employed individuals.
A solo 401(k) is a retirement plan for business owners or self-employed individuals without employees. If the only other employee is your spouse, you still qualify for a solo 401(k).
Solo 401(k) plans are available as traditional or Roth plans, giving you the flexibility to decide whether to make pre- or post-tax contributions. Also, since you are the only participant, you can change your plan whenever necessary without worrying about upsetting your employees.
Solo 401(k) Contribution Limits and Requirements
One of the unique features of a solo 401(k) is that you make both employee and employer contributions for yourself.
Solo 401(k) contribution limits for Individuals under 50 years old in 2023 are:
- The total maximum contribution is $66,000
- The maximum employee contribution is $22,500
- The maximum employer contribution is $43,500
- You can contribute 20% of w-2 income earned from a business you own that has no other employees or 25% of self-employment income, whichever is lower.
Individuals 50 and over can make an additional catchup contribution of $7,500.
To contribute the maximum amount as an employer, you must earn a w-2 income of at least 217,500 or have a self-employment income of at least $174,000.
The IRS adjusts the contributions each year to account for inflation.
Updates on the following year’s contribution limits are often made towards the end of the previous year.
Solo 401K Set-Up and Administration
Solo 401(k) plans are harder to set up and maintain than a SEP IRA account. To create a solo 401(k) account, your business must have an EIN, and you must create a plan adoption agreement. Most financial institutions have standard plan documents you can use and can set up a plan within 24 hours (although it’s best not to wait until the day your contributions are due.)
Schwab now offers Solo 401(k)s with no setup or maintenance fees without a minimum balance requirement.
Because these accounts have more requirements and administration to maintain, though the fees have been historically higher than a SEP IRA, that is no longer necessarily the case. Solo 401(k) accounts require filing a Form 5500-EZ if the plan exceeds $250,000 in assets.
Solo 401(k) Pros and Cons
Both accounts allow you to put away significant amounts of money for retirement, but let’s look at the benefits and drawbacks of each type of account.
Solo 401(k) Pros
1. Higher contribution limits
Solo 401(k) plans allow for more tax-deductible contributions to your retirement account than other accounts, with a maximum of $66,000 in 2023 or $73,500 for individuals 50 or older.
For example, the employee contribution limits are the same as a normal 401(k). But, with a solo 401(k), you can contribute up to an additional $43,500 as the employer.
2. Tax deductions from business and personal taxes
If you have a corporation eligible for a Solo 401(k), you can split the tax benefit between your corporation and your personal return. The employer contribution will be deducted on your corporate return, whereas the employee contribution will lower your taxable income on your individual return.
For self-employed individuals, both the employee and employer deductions will be taken on your individual return.
3. Offers both Roth and traditional accounts
Solo 401(k) accounts can be traditional or Roth accounts, which give you control over when you pay taxes, your contributions, and your distributions.
4. Loan Provisions
One unique benefit of 401(k) plans is that they commonly include loan provisions. These loan provisions allow you to borrow against your 401(k) balance. A solo 401(k) may allow you to take out a loan of up to 50% of your account balance or $50,000 (whichever is lower) within a 12-month period.
The benefit of a loan provision is that it offers a way to borrow money in times of financial hardship. The loan provision allows you to access funds from your retirement account while still reaping the tax benefit.
Solo 401(k) Cons
1. You can’t have any employees
Solo 401(k) plans are only available to businesses or self-employed individuals without employees.
2. Additional filing requirements and Maintenance
Solo 401(k) accounts require more filing than SEP IRA accounts, making them more costly to maintain than SEP IRA accounts. When your solo 401(k) total assets exceed $250,00, you must file an additional form (Form 5500-EZ ) on top of the other filing requirements you’ve already done.
3. Contributions: Substantial and Recurring
With Solo 401(k), contributions must be “recurring and substantial.” This requirement means that you must make contributions in three out of every five years for the plan to be considered active. The timing of these contributions is flexible.
However, you must be able to justify the contribution based on your payroll. You can’t make a $20,000 contribution if you only paid yourself $10,000.
Regarding the “substantial” requirement, contributions must be significant enough to show an intention to continue the plan.
If solo 401(k) accounts are not receiving substantial and recurring contributions, the account can be discontinued.
What is a SEP IRA?
Simplified Employee Pension IRAs (SEP IRAs) are a special type of IRA plan. SEP IRAs are designed for small-business owners with few or no employees and self-employed individuals. There is no limit on the number of employees you can have.
The SEP IRA is designed to be simple (thus the name) and requires little administration.
With SEP IRAs, only employers can make contributions. These contributions are capped at 25% of employee compensation or up to $66,000 in 2023.
SEP IRA contributions are also tax-deductible. This means that any contributions you make to your plan or your employee’s account will reduce your total taxable income each fiscal year contributions are made.
What are Eligibility Requirements for SEP IRA?
Any small business can is eligible to create a SEP IRA.
SEP IRA must apply consistent eligibility standards to employees. Each company can adjust employee eligibility requirements to fit their needs. Some standard employee eligibility requirements are listed below.
- The employee must be at least 21 years of age
- The employee must have worked with the business for three of the past five years
- Part-time employees can qualify if they have worked for the company for any time (even a few months) in three of the last five years
- Earn at least $750 in 2023; $650 in 2021 and 2022; $600 in compensation (in 2016 – 2020)
SEP IRA Contribution Limits and Requirements
There are a few key rules for contributions with SEP IRA accounts.
- The maximum annual contribution limit for SEP IRA accounts is $66,000 for 2023 or 25% of total compensation, whichever is lower
- To contribute the maximum amount to a SEP IRA account, you must earn an annual salary of at least $264,000
- Employers can choose any contribution percentage up to 25%. All employees must receive the same contribution percentage.
- Contributions can only be made by employers and not employees
- A maximum of $330,000 can be used as wages to figure out your contribution
- Contributions are vested immediately (most 401(k) plans have vesting schedules)
SEP IRA Contribution Deadline
Employers make all the contribution decisions, they can be made up to the tax filing deadline.
An advantage to the contribution deadline flexibility is that it allows self-employed individuals to contribute after you’ve calculated your net business income and evaluated your tax burden.
SEP IRA Set-Up and Administration
SEP IRA accounts are easy to set up and maintain once created.
Below is a simple three-step process that the IRA outlines for you to set up a SEP IRA:
- Execute a written agreement to provide benefits to all eligible employees.
- Disclose to employees certain information about the agreement.
- Set up an IRA account for each eligible employee.
SEP IRA accounts require little to no filing requirements unless updates are made to the plan requirements or contributions. You don’t need an EIN number like you do for a solo 401(k) account.
SEP-IRA Pros and Cons
SEP IRA Pros
1. High Contributions
As a self-employed individual, you can make large contributions directly from your business to your IRA account, with a maximum contribution of $66,000 or 25% of employee compensation, whichever is lower.
2. Contribution Flexibility
SEP IRA has no required contribution. You can adjust your contributions throughout the year based on your goals and income.
3. Contribution Deadline
The contribution deadline for SEP IRA on your tax filing deadline. Businesses and self-employed individuals can decide how much to contribute after company performance and tax obligations are clear for the year
4. Great Benefit to Entice Employees
Small businesses can use SEP IRA participation as a benefit to recruit and retain employees. The main attraction for employees is that employers contribute directly to their IRA accounts on behalf of employees.
SEP IRA accounts have no vesting period, meaning employees have ownership as soon as contributions are made.
SEP IRA Cons
1. Uniform Contributions
One downside of SEP IRAs is that, as an owner, you can’t vary your contribution amount for the different employees in your company (including yourself). This can make it difficult if you want to put a higher contribution percentage into your account.
2. Employees Can’t Contribute
There are no matching or profit-sharing contributions like other common retirement plans for employees. For SEP IRA accounts, the employer has full control over all contributions.
3. No Catch-Up Contributions
While many retirement plans offer catch-up contributions for people above 50, SEP IRAs don’t offer any increased maximum contribution amounts based on your age. This is primarily because employers make contributions, and SEP IRA accounts aim to ensure that all requirements and contributions are equal for all employees.
4. No Participant Loans
Many 401(k) accounts offer participant loans on the account’s value, but SEP IRA accounts don’t allow loans.
5. High Earnings Required To Qualify for Maximum Contribution
While SEP IRA accounts allow you to contribute more to your retirement account, you must be a higher earner to achieve this. To contribute the maximum $66,000 contribution for 2023, you must earn at least $264,000. If you earn anything below $264,00, you would only contribute 25% of your compensation.
Solo 401(k) and SEP IRA: Traditional vs Roth
Solo 401(k) and SEP IRA retirement plans have two options: a traditional or a Roth account.
The key difference between traditional and Roth plans is whether your contributions are made with pre-tax or post-tax dollars.
Traditional – Solo 401(k) and SEP IRA
- Contributions are pre-tax/tax-deductible and reduce your taxable income in the year the contribution is made.
- Distributions are taxed at your income tax rate when you receive the distributions.
Roth – Solo 401(k) and SEP IRA
- Contributions are after-tax and don’t lower your taxable income.
- Distributions are tax-free during retirement.
Roth Solo 401(k)s are a better option if you anticipate being in a higher tax bracket when your retire or expect tax brackets to increase over time. In this case, you can save money over the long run and avoid paying taxes on your distributions.
Solo 401(k) vs SEP IRA: Backdoor Roth Eligibility
The backdoor Roth is a contribution method that allows individuals exceeding the Roth income limits to continue contributing to their Roth IRA accounts.
This is an important distinction for high-income earners such as physicians because it will allow you to continue making contributions once they exceed the Roth-adjusted gross income limits of $153,000 for single filers and $228,000 for married filers in 2023.
Solo 401(k) plans have a clear advantage.
Solo 401(k) plans allow you to do a backdoor Roth without encountering issues with the pro rata rule. Making tax-deferred contributions to a SEP IRA, on the other hand, essentially makes one ineligible for a tax-free backdoor Roth conversion. To complete a tax-free backdoor Roth contribution without, any tax-deferred money in a SEP IRA must first be converted to a Roth IRA (a taxable event) or rolled over into a 401(k) (solo 401(k) or an employer’s 401(k)) before performing the backdoor Roth conversion.
Should You Invest in a SEP IRA or Solo 401(k)?
If you are self-employed or a business owner with no employees, solo 401(k) accounts have maximum contribution limits that are easier to reach and offer a smooth transition into a backdoor Roth conversion, making it a better option.
When it comes to other features, such as contribution flexibility and tax treatment, Solo 401(k) and SEP IRA accounts are equally appealing.
SEP IRA accounts have the upper hand in maintenance and set-up, but the advantages that Solo 401(k) plans offer often outweigh the additional cost and time you might have to spend.
If you are self-employed or a business owner with employees, on the other hand, you will have to use a SEP IRA account due to the eligibility restrictions of the solo 401(k). While SEP IRAs have lower administration fees, having to make matching contributions for your employees can become expensive.