Is An Individual 401k Or SEP-IRA A Better Choice For You?Submitted by Castlebar Asset Management on December 10th, 2015
SEP-IRAs (Simplified Employee Pension Individual Retirement Arrangement) have been the most common retirement plan for self-employed` individuals and small businesses owners. They allow business owners to contribute a chunk of money to their retirement plans while reducing their tax bills at the same time. Individual 401k may work better for you and have some different features that could be beneficial.
SEP-IRAs are a profit sharing plan while Individual 401k's allow you to make deferral contributions in addition to profit sharing. SEP-IRAs allow you as the owner to make a 25% contribution of profits to eligible employees or 20% if you are a sole proprietor. The max dollar amount you can contribute for 2019 is $56,000.
Features of Individual 401k's
Individual 401k's, sometimes called Solo 401k's, has the same max dollar amount of $56,000 as a SEP-IRA. You can reach your max contribution quicker using an Individual 401k since you can make an employee deferral contribution of up to $19,000. This is your contribution to your individual 401k and can be made on a pre-tax or after tax basis. Just like a SEP-IRA your business can contribute up to 25% of its profits or 20% if you are a sole-proprietor. The combination of your deferral contribution and the profit sharing cannot exceed $59,000.
For individuals over 50, Individual 401k's allow catch up contributions. You can make an additional $6,000 deferral contribution. This will increase the max to $65,000 including the profit sharing plan. The same rules apply to the profit-sharing component. SEP-IRA do not allow catch up contributions.
Let’s look at an example. If you are a 40 year old business owner and you earn $200,000 a year. Using a SEP-IRA you are able to contribute a maximum of $50,000 if you are an employee or $40,000 if you are a sole proprietor. Contributing to an individual 401k you can make a $19,000 contribution and then a $37,000 profit sharing contribution from the business. This is less than 25% or 20% since you are maxed out at $56,000. To max out your SEP IRA you would have to earn at least $224,000 as an employee at a 25% contributions level or $280,000 as a self-employed person using the 20% level.
For a 50 year old who earns $200,000, they would be able to contribute $25,000 ($19,000 deferral contribution + $6,000 catch up) and $37,000 from profits in the business. This total of $62,000 is superior to anything you can contribute to for a SEP-IRA if you are older than 50. We encourage business owners in their 50s towards Individual 401ks for this reason.
Another difference between Individual 401k or SEP-IRAs is an Individual 401k allows Roth contributions. You can make contributions on a pre-tax, after-tax or Roth basis for an Individual 401k. This means you can contribute up to $19,000 ($25,000 if you are over the age of 50) directly into an Individual Roth 401k. SEP-IRAs do not allow Roth contributions although you can convert your SEP IRA into a Roth IRA.
Individual 401k's are just like regular 401k's and can have borrowing provisions. As an Individual 401k participant you can borrow either $50,000 or 50% of your account (whichever is less) if you plan allows it. Check the details of your plan document. Loans have to be repaid in 5 years or less, payments need to be paid at least quarterly and you are charged an interest (usually prime +1%). SEP-IRAs do not allow loans to the owner without triggering prohibited transaction window. This is not advisable! Early withdrawal rules for Individual 401k's tend to be better.
Features of SEP-IRAs
There are a few more features in an Individual 401k, but there are some key items that may make a SEP-IRA the right plan for you. SEP-IRAs can be opened or adopted any time before you or your employer or your business files their tax returns. Some of our clients will also seek an extension so they can make their max contributions because they are in lumpy cash flow situation. If you are behind the curve and are not able to create a SEP-IRA before December 31 you are still ok. Individual 401k's have to be established before December 31 and you have to make your contributions by year end as well.
SEP-IRAs offer flexibility if your small business or sole proprietorship grows to a point where you add employees. You don’t immediately have to start profit sharing to any new employees. SEP-IRA’s only requires you to make profit sharing contributions to eligible employees who have worked full time for you over the last 3 out of 5 years. If you have part time employees who work less than 1000 hours, you don’t have to include them in the plan. Individual 401k's do not allow any plan participation for employees unless they are a spouse. Spouses can participate in both type of plans.
Record keeping for SEP-IRAs is very straight forward. For Individual 401k plans, there are some additional forms you have to complete with the IRS. Once your account grows over $250,000 you will need to file a Form 5500. The costs to complete this is minimal but it is something to keep in mind.
Some of the features for Individual 401k's or Solo 401k's are often overlooked and most small business owners or self-employed individuals usually default to a SEP-IRA. If you are a higher income earner the difference between the plans is small because you’ll be able to max out contributions in either account type. For people who earn $200,000 or less and want to make large retirement contributions, an Individual 401k is worth a look.
Disclaimer: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.