In our opinion, self-employed individuals should select the Individual 401(k) over the SEP IRA since, in most situations, the prospective tax savings are bigger. It can be a little more work to establish an account but the long-term benefits are worth it.
When choosing between a SEP IRA and an Individual 401(k), the main concern that many taxpayers have is “What is the maximum I can contribute?” Because you can make elective contributions from your earned income, the Individual 401(k) typically allows for a higher contribution amount and tax deduction, especially in circumstances when the individual’s self-employment income is restricted. For instance, if you earned $35,000 in 2023 and are younger than 50, you can make elective contributions to your Individual 401(k) up to the $23,500 maximum, which will completely eliminate your taxable income once you account for the standard deductions or employer profit sharing contributions you can make as well (standard deductions of $13,850 for Single tax filers and $20,800 if Married filing jointly).
But that’s not the only reason to pick a Individual 401(k). Individual 401(k)s also offer features that are more aligned with traditional employer-sponsored retirement plans that SEP IRAs lack: You can, for example, generally take out a loan from your Individual 401(k) equal to the lesser of $50,000 or 50% of your account balance. Some providers do not allow loans so it is always best to check with the brokerage firm ahead of time if this is an option.
The Individual 401(k)s also offer catch-up contributions for people 50 and older as well as a Roth option in which you pay income tax now in exchange for tax-free withdrawals in retirement. The Roth option is likely one of the most impactful benefits of the Individual 401k as a retirement saving and tax planning vehicle.