Oftentimes, there is a lot of appeal to being a 1099 independent contractor and/or a business owner, especially when it comes to the flexibility of retirement contributions. The purpose of this article is to strictly focus on a single business owner of independent contractor who is weighing the pros and cons of the SEP vs Solo 401(k), and outline the metrics that may be necessary to understand in order to make a well informed decision.
Before we start, let's set the stage with some hypotheticals. You are a sole business owner under the age of 50, you have no employees, and because you file as an S-Corp, you pay yourself a salary of $120,000 per year. In addition to the salary you pay yourself, at the end of the year you end up with $400,000 of net profit that you take as a distribution. If you want to get into the semantics of balancing salary vs distribution, you can book a meeting here and we can discuss this as it pertains to your specific situation.
The SEP IRA
This is a very popular retirement plan for it's ease of implementation, and often, lower cost to set up. SEP IRA's can invest in anything from individual stocks, bonds, mutual funds, ETFs, and more, with the potential to even have a self-directed SEP IRA that may allow for alternative investments like real estate, private equity, etc.
If we focus solely on the contributions to the SEP IRA, to keep things simple, on a $120,000 salary you are able to contribute up to 25% of income or $70,000, whichever is less. This would result in a maximum contribution to the SEP IRA (assuming we are in 2025) of $30,000.
Taking into account the salary of $120,000 minus $30,000 for the SEP IRA contribution, plus the $400,000 distribution, the total income that would hit the tax return would be $490,000. If you were married and filing jointly, that $30,000 contribution may result in about $10,500 of tax savings ($30,000 x 35%).
The Solo 401(k)
Growing in popularity in recent years is the solo 401(k) plan. There's many benefits to a 401(k) plan vs a SEP IRA, such as Roth contributions, loan provisions, and employee deferrals, the latter of which we will illustrate.
Taking the same scenario as above, $120,000 of salary, $400,000 of distributions, and the goal of maximizing retirement contributions for the year, the solo 401(k) plan allows for employee contributions, employer matching contributions, and profit sharing contributions.
Employees (you in this scenario) can contribute up to $23,500 (in 2025) of their income into a 401(k) plan. An employer (also you) can then make matching/profit sharing contributions each year to your employees (remember, that's you). On a $120,000 income, that can be 25% which is, like the SEP IRA, $30,000. So the total that can be deferred into the solo 401(k) is then $53,500 for the year ($23,500 employee contributions plus $30,000 employer contributions). If you wanted to maximize the income deferrals to hit $70,000 of annual contributions, you would then need to take your salary to $186,000 which would allow the 25% of employer contributions to be $46,500 for the year, with the employee $23,500 contribution added to that for a total of $70,000.
In order for the SEP IRA to maximize income deferrals to reach the $70,000 limit, you would need to pay a salary of $280,000 for the year which would also require paying an additional 1.45% on medicare taxes on the salary portion.
If we keep tax rates simplified for this example, a $520,000 income ($120,000 salary plus $400,000 distribution), would put someone in the 35% marginal tax bracket.
The SEP IRA may reduce income by $30,000 whereas the solo 401(k) may reduce income by $53,500. This would result in a potential tax savings of $18,725 at the 35% bracket for the solo 401(k) vs $10,500 of potential tax savings for the SEP IRA. Even with higher administration expenses for a 401(k) plan, they shouldn't come close to $8,000 per year.
As you may now realize, a retirement plan for your business can be a valuable account to not only help save for retirement but also potentially help significantly reduce your tax bill each year. Always consult your accountants and CPA's before making these decisions and coordinate that work with a financial advisor who can help you think through these strategies in detail.
Our team works with business owners and independent contractors to help set up these types of plans and we would love to be a resource for you and your business. You can reach out to us anytime and book a meeting directly on my calendar using this link.
Blake