Self-Employed Retirement Planning: Individual 401(k) or SEP IRA?

Liz Revenko / Jul 25, 2017 / Retirement Planning

Working for yourself can be pretty great. As the boss, you can set the dress code at “jammies.” While you miss out on having a 401(k) plan set up for you (along with an HR department reminding you to make contributions), you can take care of those things pretty simply yourself. And you should, because as a self-employed worker, you have access to more and better retirement plan options than most people who are working for someone else.


Two of the most popular retirement savings accounts for the self-employed are Individual 401(k)s, otherwise known as Solo 401(k)s, and SEP IRAs. You’ve probably heard of both of these. Which is best for your situation?

An Individual 401(k) is tops for flexibility and socking it away

An Individual 401(k), sometimes referred to as an I401(k), is a lot like the 401(k) offered by a traditional employer, but often better in terms of being able to sock away money. Why? Because you employ yourself. You get to make contributions as an employee—and also as an employer.  

  • Just like your corporate working counterparts, you can make an employee contribution of up to $18,000 ($24,000 if you’re over fifty)
  • Additionally, as an employer, you can contribute 20% of your net earnings from self-employment, as long as your total employer and employee contributions don’t top $54,000 ($60,000 if you are over fifty)

How much you can contribute is linked to how much you earn. You can contribute 100% of the first $18,000 of self-employment income ($24,000 if you are over fifty) as your employee contribution.

On top of that, you can contribute 20% of your net self-employment income, up to a total of $54,000, or $60,000 with the over fifty “catch up” provisions.


Making use of the Roth option for an Individual 401(k) can be a great long-term tax move

For many Individual 401(k) plans, you have the option of investing your employee contribution in a Roth 401(k). If you choose this, you do not get a tax deduction for your contributions. But, down the road when you take out the money for retirement, your withdrawals are tax free. Having a source of tax-free income in retirement can be incredibly valuable.

You can make Roth contributions for your employee contribution, but not the employer portion.  Having both Roth and regular options at play in your Individual 401(k) gives you flexibility in your tax planning, now and in the future.


Mega Backdoor Roth: Supersize your Roth option in an I401(k)

Less well known is that some Individual 401(k) plans allow you to make after-tax contributions, which can then be converted to a Roth. This is also known as the “mega backdoor Roth.” Typically you need to work with a professional to set up your Individual 401(k) to allow for this, but for those looking to maximize their Roth contributions, it can be extremely worthwhile.

Here’s an example. Let’s assume you are under fifty and earn $100,000 as a self-employed worker.

Under the typical Individual 401(k), as explained above, you start by making an $18,000 employee Roth 401(k) contribution. Then you add 20% of your net income to your regular 401(k) as your employer contribution. About half of your contribution is in Roth, and half is not, and the total you put away is about $36,000.

With the “mega backdoor Roth” tactic, you still start by making your $18,000 employee Roth 401(k) contribution. Then, instead of making that “employer contribution,” you make use of your awesome self-employed benefits and make an additional $36,000 after-tax employee contribution. This not only gets you all the way to the $54,000 maximum, but you can convert the $36,000 after-tax contribution to a Roth, bringing your total Roth contribution to $54,000. For those who seek to maximize their Roth accounts, this can be a fantastic retirement tool.

This isn’t the best solution for everyones self-employed retirement planning, of course. You’ll need to consider taxes, cash flow, and your personal circumstances to see how this plays out over each year, and in the long run—a financial planner can be a great help with these decisions.  


You may not be able to put as much into a SEP IRA, but it can be a savior if you haven’t planned ahead  

SEP IRAs allow you to make only the employer contribution portion. You can add 20% of your net earnings from the business, up to a maximum of $54k for 2017 (there are no over-fifty catch up provisions in a SEP). If you make at least $270,000, you can max it out. But if you earn less, you can sock more away in an Individual 401(k).

What’s great about SEP IRAs is that you can set them up the day you file your taxes, including extensions.

Individual 401(k)s, on the other hand, have to be set up by December 31 of the year for which you are claiming the deduction.

When it comes to retirement planning, as a self-employed worker, you really can have it better than your corporate friends. Even if you don’t wear jammies or have a commute that’s literally a walk down the hall.


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Topics: Retirement Planning