Self-Employed Retirement Planning–the SEP IRA vs. Solo(K)

By Steve Gelber on November 1, 2023

There are many different types of retirement plans and accounts. While the IRA and Roth IRA are available to all qualifying savers, the relatively low contribution limits ($6,500 in 2023 and $7,000 in 2024, with a $1,000 catch up contribution for those aged 50 and older) force the self-employed to seek alternative funding vehicles for measurable tax savings and to make a more substantial dent in their retirement savings needs.

Very often, self-employed individuals will defer to using a SEP IRA to defer income and save for their retirement because it is an easy-to-establish plan and, with it often being incorrectly referred to as a “Self-Employed Plan,” it must be the best option. For the small business owner with even one employee other than themselves, I would be very cautious to look at the SEP IRA over other plans designed for small businesses (such as the Simple IRA or a 401(k)). There are many reasons for my trepidation, but the most important being that you will be required to treat all employees “equally” to yourself. Therefore, you will need to make equal contributions (relative to compensation) for employees as you make for yourself—which could be a substantial expense. If you are self-employed, or even if you have a “side gig,” and are looking to defer income and save for retirement, you are likely (and rightfully so) considering the SEP IRA, but you should understand the differences between a SEP IRA and the newer less commonly used Individual (“Solo”) K so that you can make the most informed decision.

The SEP IRA

A great option for the high earning self-employed

The Simplified Employee Pension allows for the self-employed to defer a portion of their income up to a contribution limit of $66,000 for 2023. While the IRS publishes the limit on deferrals as 25% on income up to $330,000, there is a glitch in the formula. Since the amount of the contribution into your SEP IRA counts as an expense, or reduction to your profits, the actual effective amount that you can contribute is 20% of your income. While the calculation can be a bit tricky and you should always confirm how much you can contribute with your tax professional, if you limit your contribution to 20% of your profits and do not exceed $66,000, you should be safe.

A SEP IRA can be opened and funded at most all custodians and you can establish a SEP IRA right up to the tax filing deadline in order to qualify for the deduction. Many accountants would prefer that you make your contribution prior to the end of the year, as making your 2023 contribution in calendar year 2024, while proper, can be a bit of a book-keeping headache.

While you can open the SEP IRA if you have employees, they must be allowed to participate if they are aged 21 or older, earned at least $750 for the 2022 tax year, and have worked in at least 3 of the past 5 years (the employer can make requirements less, but no more, restrictive). The SEP IRA is potentially costly if you have employees because you will be required to make the same contributions for your employees (as a percentage of their compensation) as you make for yourself.

The Individual (“Solo”) K

A potentially more flexible option offering potentially higher deferrals

The Individual, or “Solo,” K is an alternative to the SEP IRA with potentially higher and less restrictive contribution limits. If you are self-employed, or have a “side gig” from which you would like to defer income, the Individual K may be a more attractive option for you. The Individual K is a lot like the traditional 401(k) plan offered by employers, but it is reserved for solo practitioners (and businesses with only owners/partners) with no employees (other than a spouse).

Within the Individual K, there are two types of contributions—employee and employer. As an employee, the solo practitioner can defer the lesser of $22,500 or 100% of compensation for 2023. In 2023, this limit will rise to the lesser of $23,000 or 100% of compensation. In addition, you can contribute an additional $7,500 (subject to the same 100% of compensation limit) if you are aged 50 or older. As an employer, additional contributions can be made using the same qualifying calculation up to the same $66,000 total contribution limit of the SEP IRA (a total of $73,500 for those aged 50 and older).

As you can see, for the solo practitioner, it is easier to calculate and qualify to make contributions to the Individual K. For example, let’s take the case of Jim, a 55-year-old who has a full-time job but earns some consulting income for work that he does on the side. Jim earned $50,000 from consulting in 2023 and would like to not only defer some of that income tax liability but save for his retirement. Using a SEP IRA Jim will only be able to contribute about $10,000. However, with the Individual K, Jim will be able to make an elective employee contribution of $22,500 and an employee catch up contribution of $7,500. By using an Individual K, Jim will have deferred $30,000 of his $50,000 in self-employment earnings while helping fund his retirement. Jim can also make an employer contribution to further defer income and pad his retirement savings. If Jim is participating in a retirement plan at his full-time job he must be careful to coordinate his contributions with his workplace plan so that his total contributions across all eligible plans do not exceed the contribution limit (participating in more than one plan does not increase his total contribution limit across all plans).

In addition to a higher contribution, the Individual K will give Jim more options and flexibility.

For those tax savvy savers who are not seeking to defer all of their taxes but are rather looking for a tax advantaged retirement savings vehicle, Roth (after tax and future tax-free growth) employee contributions are available in the Individual K, but not in the SEP IRA.

In the future, if Jim has an emergency and needs to access the funds that he deferred he can also take a loan against his Individual K balance. Much like the Traditional 401(k) Jim can take a loan (if your selected custodian allows) of the lesser of 50% or $50,000 of his Individual K balance. Loans are not allowed with the SEP IRA.

Procrastinators beware.

Unlike the SEP IRA, an Individual K must be opened, and the deferral election made, by December 31st in order to qualify for the tax year. Therefore, you will need to open an Individual K and make your elective deferral of up to $22,500 (or $30,000 if aged 50 or older) prior to year-end. The same tax filing deadline for opening the account is not available to the Individual K.

In summary, whether a self-employed person decides to utilize the SEP IRA or Individual K, they are on the right track to deferring income and saving for their future retirement needs. However, the lesser known and utilized Individual K may provide for larger contributions, more tax advantaged ways of saving, and more flexibility to the saver.

If you have any questions regarding available retirement plan options for you or your small business, please do not hesitate to contact our office.

Hightower Advisors, LLC is an SEC registered investment adviser. Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.