401(k) vs. SEP IRA for small businesses

Choosing a suitable retirement plan for your business can often be overwhelming. If you are deciding between a 401(k) plan and a Simplified Employee Pension Individual Retirement Account (SEP IRA), you may want to understand the differences between these two types. A 401(k) plan is a traditional retirement plan available for small and large businesses. This article will help you understand the differences between a solo 401(k) vs. a SEP IRA for a small business.

What Is a Solo 401(k)?

A solo 401(k) plan is a retirement plan suitable for a self-employed individual who wants to contribute more than what’s allowed under traditional and Roth IRAs. You can take advantage of this plan if you and your spouse are the only employees in your business.

You make contributions into your solo 401(k) from your pre-tax income and deduct these contributions as business expenses. You don’t have to pay any tax on your investment earnings until you withdraw your funds. Alternatively, you may also choose to set up a Roth solo 401(k). With this option, you can fund your account with post-tax earnings and become eligible for tax-free withdrawals.

According to the IRS, the contribution limits for a solo 401(k) account are the same as those for corporate 401(k) plans. As an employee, you can contribute up to $23,000 per year, or $30,500 if you are 50 years and older.

You can also contribute to your solo 401(k) account as an employer. The maximum contribution in these cases cannot exceed 25% of your compensation, as defined by the Internal Revenue Service (IRS). The IRS computes your compensation by deducting the following components from your net self-employment earnings:

• 50% of your self-employment tax.

• Contributions made to your own retirement plan.

According to the IRS, the maximum amount of compensation for computing your contribution can’t be more than $345,000. Moreover, your combined contribution as an employer and an employee can’t be more than $69,000. You can make an additional contribution of $7,500 if you are 50 years and older.

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What Is a SEP IRA?

If you are a small business owner with a few employees, a Simplified Employee Pension plan, commonly known as a SEP IRA, may be more suitable for you. This plan lets you contribute to your employees’ retirement and your own.

A SEP IRA works like a traditional IRA in that you can deduct your contributions from your taxable income. Your investment continues to grow tax-free, and you pay tax only when you make withdrawals.

However, a SEP IRA offers some benefits, which are not available in a traditional IRA. For example, you cannot contribute more than $7,000 in a traditional IRA ($8,000 if you are 50 years or older). A SEP IRA allows higher contribution limits. You can contribute up to $69,000, provided your contributions do not exceed 25% of your pay.

SEP IRA vs. 401(k) Plan

A SEP IRA differs from a 401(k) plan in the following ways:

• Suitability: A SEP IRA is available to small business owners and self-employed individuals, including sole proprietors, partnership firms, and corporations. On the other hand, a 401(k) plan is suitable for private and public companies with 20 or more employees.

• Contribution Limits: According to the IRS, in a SEP IRA, you can contribute up to 25% of compensation subject to a maximum of $69,000. However, in a 401(k) plan, you can contribute up to $23,00 plus a catch-up contribution of $7,500 if you are 50 years or older.

• Administrative Responsibilities: In a SEP IRA, employers do not need to file tax returns, but employees must be notified with respect to an employer’s contribution if any. However, in a 401(k) plan, you must file Form 5500 and comply with special IRS testing designed to ensure that the plan does not favor any employee with a high compensation package.

• Access to assets: In a SEP IRA, you can make withdrawals at any time subject to a penalty of 10% if you withdraw before the age of 59 ½ years. However, in a 401(k) plan, you cannot make withdrawals before the age of 59 ½ years except in certain cases such as disability or plan termination, although you may make hardship withdrawals subject to a 10% penalty.

SEP IRA vs. Self-Employed 401(k) Plan

A SEP IRA differs from a self-employed 401(k) plan with respect to the following features:

• Suitability: Both plans are available to small business owners and self-employed individuals. However, unlike a SEP IRA, which is available to businesses with or without employees, you qualify for a self-employed 401(k) plan only if you have no employees other than your spouse.

• Contribution Limits: According to the IRS, a SEP IRA allows you to contribute up to 25% of compensation subject to a maximum of $69,000. In a self-employed 401(k) plan, you can contribute up to $23,000 plus a catch-up amount of $7,500 if you are 50 years or older.

• Administrative Responsibilities: Employers do not need to file any tax returns in a SEP IRA. However, in a self-employed 401(k), you must file Form 5500 annually after your plan assets exceed $250,000, according to IRS regulations. You must also file documents for amendments in the plan required due to legislative changes.

• Access to assets: According to the IRS, a SEP IRA allows you to make withdrawals at any time subject to a penalty of 10% for withdrawals made before the age of 59 ½ years. In a self-employed 401(k), you cannot make withdrawals before the age of 59 ½ years except in certain cases such as disability or plan termination.

If you need any help deciding upon a suitable retirement plan for your organization, contact our experts. At Human Interest, we specialize in offering affordable and easy retirement plans to small and mid-sized businesses. We would be happy to assist you with our professional guidance.