Tax-Advantaged Accounts for the Self-Employed

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Figuring out the most effective way to save for retirement can be confusing for anyone, but for the self-employed, the challenge is often amplified. Without the options that traditional employers provide, freelancers, consultants and other solo entrepreneurs must carve their own path.

For most, the choice boils down to two types of tax-advantaged accounts: the solo 401(k) and the Simplified Employee Pension (SEP) IRA. Here’s the rundown on both plans, including advice on how to decide which is the best fit for you.

Solo 401(k) tax-advantaged accounts

Often referred to as a solo-k or individual 401(k) plan, the solo 401(k) is tailored specifically for businesses in which the only employee is the owner (and possibly their spouse). The solo 401(k) has a dual contribution structure.

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As an employee, you can make elective deferrals up to the standard 401(k) limit, which is $23,000 in 2024, with catch-up contributions of up to $7,500 allowed for those 50 and older.
As an employer, you can also contribute up to 25% of your compensation. The combined total cannot exceed $76,500.

While traditional solo 401(k) contributions are tax-deferred, some providers offer a Roth option. Contributions to a Roth solo 401(k) are after-tax, but the money will grow tax-free, and contributions and earnings can be withdrawn tax-free as long as you’re 591⁄2 and have owned the plan for at least five years.

Another distinctive feature of the solo 401(k) is the ability to borrow from your account. Although this can slow the growth of your retirement savings, it provides a source of funds in an emergency or cash-flow crisis.

SEP IRA plan for the self-employed

The SEP IRA allows business owners to set up individual retirement accounts for themselves and, if they have them, their employees. For 2024, if you’re self-employed you can contribute the lesser of 20% of your net income or $69,000 to a SEP IRA. Unlike a solo 401(k), a SEP offers no option for elective deferrals or catch-up contributions. SEP IRAs generally have fewer administrative requirements than solo 401(k) plans, which may make them attractive for workers looking for a streamlined way to save. However, you can’t borrow from a SEP IRA, so your only choice to raise cash in an emergency would be taking a taxable distribution from your plan.

Legislation enacted late last year allows SEP providers to offer a Roth option, but it may be a while before providers make the administrative changes necessary to offer a Roth SEP IRA.

401(k) or SEP IRA: Which is better?

If you’re looking to maximize your contributions, the solo 401(k)’s dual contribution structure provides the most effective way to save. Likewise, if you’re keen on post-tax retirement savings, the Roth feature of some solo 401(k) plans could be a game-changer, allowing for tax-free withdrawals in retirement.

If you prioritize simplicity and want to minimize paperwork, the SEP IRA has an edge. It’s straightforward to set up and maintain. And if you anticipate hiring employees other than your spouse, a SEP IRA is probably the better choice, although keep in mind that you’ll be required to contribute an equal percentage of salary for all eligible employees.

A certified financial planner who has experience working with business owners can help you choose a plan that aligns with your long-term goals. Search for a planner at www.financialplanningassociation.org/about/for-consumers.

Note: This item first appeared in Kiplinger's Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.

Ashlyn Brooks is a financial writer and former civil engineer. She's on a mission to show others how to save and spend smarter through purposeful money habits. Her work has been featured on Investopedia, Bankrate and Yahoo Finance.