Self-Employed Investing: SEP-IRA, Solo 401(k), and Irregular Income

Key Takeaways

• Solo 401(k): contributions as both employee (up to $23,500 elective deferral in 2026) and employer (up to 25% of net self-employment compensation). Total combined limit: $70,000 in 2026.
• SEP-IRA: employer contributions only, up to 25% of net self-employment compensation or $70,000. Simpler to administer; can be opened and funded as late as the tax filing deadline including extensions.
• Self-employed individuals pay both the employee and employer portions of Social Security and Medicare taxes (self-employment tax). Half of the self-employment tax is deductible from gross income when calculating net self-employment compensation for retirement plan purposes.
• Quarterly estimated tax payments are due April 15, June 15, September 15, and January 15 for most self-employed individuals. Underpayment can result in penalties.
• A defined benefit (pension) plan for a sole proprietor can allow even higher contributions than a Solo 401(k) for high-income self-employed individuals who want to maximize pre-tax savings.

Solo 401(k) vs. SEP-IRA

Both the Solo 401(k) and the SEP-IRA allow self-employed individuals to save for retirement with high contribution limits and tax deductions. The key difference is the structure of contributions.

Solo 401(k): You contribute as both the employee (elective deferral up to $23,500 in 2026) and the employer (profit-sharing contribution up to 25% of net self-employment compensation). The employee contribution can be made up to the total $23,500 regardless of income level, making the Solo 401(k) more efficient at lower income levels. A Solo 401(k) also allows Roth contributions (though Roth profit-sharing contributions are generally not available). The plan must be established by December 31 of the contribution year.

SEP-IRA: Only employer contributions are allowed, up to 25% of net self-employment compensation (after the deduction for half of self-employment tax) or $70,000, whichever is less. A SEP-IRA is simpler to administer and can be established and funded as late as the tax filing deadline including extensions, giving more flexibility. No Roth option is available for SEP-IRA contributions.

Net Self-Employment Compensation Calculation

The retirement contribution calculation for self-employed individuals uses net self-employment compensation, not gross income. Net self-employment compensation is: gross self-employment income, minus business expenses, minus the deductible portion of self-employment tax (which is half of the total self-employment tax calculated on Schedule SE). For a SEP-IRA, the contribution rate is effectively about 18.59% of net self-employment income (not 25%) because the contribution is made on the compensation after reducing it by the contribution itself.

Managing Irregular Income

Self-employed income is unpredictable. A practical system for managing irregular income is to immediately set aside 25 to 30 percent of each payment received into a designated account for taxes and retirement. When quarterly estimated taxes are due, draw from this account. At year end, calculate actual net income and determine the final retirement contribution amount based on what the plan formula allows. This approach treats tax and retirement obligations as first-dollar costs, avoiding the behavioral tendency to spend irregular income as it arrives.

Health Insurance Deduction and HSA

Self-employed individuals can deduct health insurance premiums for themselves and their family from gross income (not self-employment tax, just income tax). Combining a high-deductible health plan with an HSA creates a third tax-advantaged account: HSA contributions are deductible, growth is tax-free, and withdrawals for qualified medical expenses are tax-free. The 2026 HSA contribution limit is $4,300 for self-only and $8,550 for family coverage.

Frequently Asked Questions

What is the contribution limit for a Solo 401(k)?

A Solo 401(k) allows contributions as both employee and employer. For 2026, the employee elective deferral limit is $23,500 ($31,000 for those 50 and older, or $34,750 for those aged 60 to 63 under SECURE 2.0). The employer profit-sharing contribution can add up to 25% of net self-employment income (after the deduction for half of self-employment tax). The combined employee plus employer total cannot exceed $70,000 (2026 limit, or $77,500 for those 50 and older). The Solo 401(k) plan must be established by December 31 of the year for which contributions will be made.

What is the contribution limit for a SEP-IRA?

A SEP-IRA allows employer contributions only (not employee elective deferrals). The contribution limit for 2026 is the lesser of 25% of net self-employment compensation (after the deduction for half of self-employment tax) or $70,000. A SEP-IRA is simpler to administer than a Solo 401(k) and can be opened and funded as late as the tax filing deadline, including extensions (typically October 15 for individuals who file an extension). SEP-IRA contributions are fully tax-deductible as a business expense.

How should self-employed investors handle irregular income and investing?

Self-employed investors often benefit from setting aside a fixed percentage of each client payment for taxes and retirement rather than saving a fixed dollar amount. A common approach is to set aside 25 to 30 percent of gross receipts into a separate account designated for quarterly estimated taxes, then determine the retirement contribution amount at year end based on actual net income. Automating a percentage of each payment into savings immediately upon receipt reduces the behavioral temptation to spend irregular income as it arrives.