Ask Kim
SEP vs. Solo 401(k)
One is more widely available; the other likely will let you invest more money.
By Kimberly Lankford, Contributing Editor, Kiplinger's Personal Finance
August 2, 2007
I'm self-employed and am trying to decide where to invest for retirement. Which would be better: a Simplified Employee Pension (SEP) or a solo 401(k)?
The SEP is easier. It's available through most mutual fund companies and brokerage firms, generally with the same range of investment choices as their IRAs. But you may be able to contribute more money by opening a solo 401(k).
Contributions to a SEP are limited to 20% of your business income (which is business income minus half of your self-employment tax), up to a maximum of $45,000. With a solo 401(k), on the other hand, you can contribute up to $15,500 plus 20% of your business income (defined the same way as above), with a maximum contribution of $45,000 in 2007. You can make an extra $5,000 catch-up contribution if you're 50 or older.
Because the first $15,500 is not based on a percentage of your income, then you'll generally be able to contribute a lot more to a solo 401(k) than you can to a SEP, especially if you earn just a little extra money from a freelance job. You can't contribute more than your business income for the year, but if you earn just $15,500 from self-employed freelancing, for example, then you can contribute the whole amount to a solo 401(k).
If you have a regular 401(k) through an employer and have some freelance earnings on the side, then your solo 401(k) limits will be reduced by any contributions you've made to a regular 401(k). But that only affects the first $15,500 of contributions, not the 20% of business income. So if you contributed $10,000 to a regular 401(k) through your employer, for example, then your solo 401(k) contributions will be limited to $5,500 plus 20% of your business income -- which would still put you ahead of a SEP.
Many brokerage firms and mutual fund companies do not offer solo 401(k)s, however, and the fees and investment choices can vary a lot by company. Carolyn McClanahan, a certified financial planner in Jacksonville, Fla., generally recommends Fidelity's self-employed 401(k) because of the good investment choices, low costs and help with the required tax forms. "Most of my clients are able to save significant amounts because of the solo 401(k)," she says.
For more information about companies offering solo 401(k)s, see 401khelpcenter.com.