If you run your own business in Metro East Illinois, retirement planning tends to land somewhere below “clean out the work truck” on the to-do list. Tax season comes and goes, the quarterly estimated taxes for Illinois self-employed folks get paid, and saving for retirement stays on the “eventually” pile.
The catch is that every year you wait, you skip a deduction you could have had, because what you put into a self-employed retirement plan generally comes off your taxable income.
Two plans come up again and again for self-employed people and solo business owners: the SEP-IRA and the Solo 401(k). They do the same basic job and land at similar ceilings for high earners, but they work differently, and picking the wrong one can cost you deduction room, flexibility, or a deadline you didn’t know you had.
We’ll walk through both so you can tell which retirement plan option for Illinois self-employed fits the way you actually run your business.
The SEP-IRA Is Built For True Solo Operators
Simplicity is the SEP-IRA’s big selling point. SEP stands for Simplified Employee Pension, and it lets a self-employed person put in a percentage of net self-employment income each year, up to a dollar cap the IRS adjusts for inflation. The IRS lays out the current percentage, the dollar limits, and the plan rules in IRS Publication 560.
There’s very little paperwork, and the IRS says that generally the employer has no annual filing requirement for a SEP, including Form 5500. Every dollar going in counts as an employer contribution, which means it comes from you as the business owner, and there’s no separate salary-deferral piece. If you have eligible employees, you have to contribute the same percentage of their pay that you contribute for yourself, and that’s why SEP-IRAs are most popular with people who work alone.
The deadlines are where a SEP really shines. According to the IRS SEP plan page, you can set one up as late as your business tax return’s due date, including extensions, and you can fund it by that same extended due date. For a sole proprietor on an extended return, that usually means you can open and fund a SEP well into the following fall and still count it for the prior year.
The Solo 401(k) works a little differently, because it splits what you put in into two buckets.
The Solo 401(k) Works From Two Contribution Buckets
A Solo 401(k), which you’ll also hear called an individual 401(k) or a one-participant 401(k) plan, covers a business owner with no employees, or the owner and their spouse. It’s a regular 401(k) under the hood, with contributions split between an employee side and an employer side, and having both buckets is usually how the Solo 401(k) wins on total contribution room.
On the employee side, you can defer part of your self-employment income up to the IRS annual limit, and once you’re 50 or older, the plan can let you add a catch-up amount on top. On the employer side, the business can add a percentage of net self-employment income, up to the IRS ceiling for employer contributions. Publication 560 covers both sides, including the current-year figures and the catch-up rules.
The setup deadline used to be the Solo 401(k)’s big trap, and it’s the part that changed recently. Under SECURE 2.0, starting with 2023, a sole proprietor with no employees can adopt a Solo 401(k) after the year ends, as long as the plan is adopted by the tax filing deadline without extensions. For most calendar-year filers, that’s mid-April. The salary deferrals for that first year also have to be paid into the plan by that same unextended deadline, so an October extension doesn’t buy you more time on the employee side.
Setting it up before December 31 is still the easier road, since you can make deferrals during the year instead of scrambling in April.
Which Plan Lets You Contribute More Money?
At lower and middle income levels, the Solo 401(k) usually lets you put away more, because the employee deferral isn’t tied to a percentage of your profit. A SEP-IRA contribution is figured purely as a percentage of net self-employment income, so someone with a modest profit can only put in a fraction of what the Solo 401(k)’s employee deferral would allow.
As your income rises, the SEP’s percentage-based contribution grows, and the gap narrows. At higher incomes, both plans head toward the same overall dollar ceiling, so the SEP’s simplicity gets more appealing once you’re near the cap either way. As a rough guide, if your net self-employment income is modest to mid-range, we’d run the Solo 401(k) numbers first. If you’re a high earner who’s already close to the employer-side ceiling, the two plans end up much closer to even.
What Illinois does with these contributions matters as well, so we’ll turn to that next.
Does Illinois Tax SEP-IRA or Solo 401(k) Contributions?
On the front end, contributions to either plan generally lower your federal adjusted gross income. Illinois starts its own return from that number, since the IL-1040 instructions tell you to enter the adjusted gross income from your federal return. So a deduction that lowers your federal AGI lowers your Illinois starting point too, and at Illinois’s flat rate that adds up over the years.
On the back end, Illinois is one of the friendlier states for retirees. Illinois lets you subtract federally taxed distributions from IRAs, SEP plans and qualified plans like a 401(k), which the Illinois Department of Revenue spells out in its Illinois retirement income publication. For an Illinois business owner, that’s a nice combination: a deduction on both returns now and no Illinois income tax on those withdrawals later, as long as you’re still an Illinois resident when you take them.
How this fits with the rest of your Illinois picture is worth mapping out before year-end instead of in April. If you’d like a clearer view of where retirement contributions sit in your broader plan, that’s the kind of thing our year-round business tax planning work is built around.
SEP-IRA vs Solo 401(k): The Paperwork And Setup Difference
The SEP-IRA wins on simplicity by a wide margin. Many owners use the IRS model agreement, Form 5305-SEP, keep a signed copy with their records, open the account, and that’s about it. There’s generally no annual filing with the IRS, and the only real job left is getting contributions in before the deadline.
A Solo 401(k) needs a written plan document, which most brokerages hand you as part of their Solo 401(k) package. Once plan assets reach $250,000 at the end of a year, you’ll generally need to file Form 5500-EZ every year. The brokerage usually keeps the plan document updated, but it’s still more upkeep than a SEP asks of you. If your books are behind, get your bookkeeping and accounting in shape first.
Roth is the other difference, and it’s narrower than it used to be. Many Solo 401(k) plans let you make Roth deferrals, where you skip the deduction now, and the money can come out tax-free in retirement if you follow the rules. SEP-IRAs can now take Roth contributions too, thanks to SECURE 2.0, but the IRS notes that employers may choose to accept Roth contributions and aren’t required to, and plenty of providers haven’t added it yet.
Whether Roth matters depends on your bracket now versus what you expect in retirement.
Adding Employees Changes Both Plans In Different Ways
Once you hire, things shift. The Solo 401(k) only works when the only people covered are you and your spouse, so bringing on an employee who meets the plan’s eligibility rules usually means moving to a regular 401(k) or a SIMPLE IRA.
The SEP-IRA allows employees, but the math gets expensive in a hurry. Whatever percentage of your own income you put in, you have to put the same percentage in for every eligible employee. For a one-person shop, the SEP is easy, but for a business with even a couple of employees, those required contributions can make it a lot more costly than it first looks.
If hiring is on the calendar for the next year or two, it makes sense to revisit your plan before you post the job, not after the first paycheck goes out. Your entity choice plays into this too, and we’ve written about when an Illinois business should switch to an S-Corp, since that changes what counts as compensation for these plans.
When Should You Open A Retirement Plan As A Self-Employed Person In Illinois?
The right time is the year your self-employment income gets steady enough to support a contribution. For most Metro East small business owners, that means the plan should be in place by the end of the first profitable year, even if the first contribution is small.
If you’re already profitable and don’t have a plan, a SEP-IRA is still the most forgiving way to get a deduction for this tax year, since you can open and fund it up to your extended filing deadline. If you’d like the extra room a Solo 401(k) can offer, setting it up before December 31 keeps things simple. If you miss that, a sole proprietor with no employees can still adopt one by the April filing deadline and make first-year deferrals by then, so fall is a good time to decide which way you’re going.
If you’re not sure which plan fits your income and business setup, that’s a good question to talk through with a CPA before the year closes out, and we’re happy to run the numbers with you.
Ready to figure out which plan makes sense for your business?
Reach out to Thompson Flaherty, and we’ll walk through your numbers together. The first conversation is free, and there’s zero pressure
