A guide to switching from a SEP IRA to a 401(k)

Many businesses start their retirement savings journey with a Simplified Employee Pension (SEP) IRA. It's a popular, low-cost, and easy-to-administer plan. However, as your business grows, you may find that a 401(k) plan offers greater flexibility, higher contribution potential for employees, and more advanced features like employee deferrals and plan loans.

But can you sponsor a 401(k) plan if you already have a SEP? The answer is: it depends entirely on the type of SEP you have.

Be aware that having both a SEP and a 401(k) at the same time, or even in the same year, can lead to significant compliance issues. It's essential to understand the difference between the two types of plans to prevent potential regulatory problems.

The two types of SEP plans: 5305-SEP vs. Prototype SEP

Not all SEP plans are created equal. The plan's governing document dictates whether you are allowed to sponsor another retirement plan.

1. The IRS Model SEP (Form 5305-SEP)

This is the most common type of SEP, created using the official IRS "model" document, Form 5305-SEP, Simplified Employee Pension - Individual Retirement Accounts Contribution Agreement.

• What it is: A simple, standardized, two-page form provided by the IRS that any eligible employer can fill out to establish a plan.

• The critical restriction: The instructions for Form 5305-SEP are explicit. An employer cannot use this form if they "currently maintain any other qualified retirement plan." A 401(k) is a "qualified retirement plan." This means if your SEP was established using Form 5305-SEP, you are prohibited from sponsoring a 401(k) at the same time.

2. The Prototype SEP

This is a non-model SEP plan document that is designed by a financial institution (like a bank, insurance company, or third-party administrator) and approved by the IRS.

• What it is: A more complex and flexible plan document than the simple 5305-SEP form.

• The key difference: A prototype SEP can be drafted to permit the employer to also maintain another qualified plan, like a 401(k). These documents must contain specific language to coordinate the contribution and deduction limits between the two plans as required by the Internal Revenue Code.

Funding a 5305-SEP and a 401(k)

The most common compliance error occurs when a plan sponsor with a 5305-SEP tries to start a 401(k). You cannot fund a 5305-SEP and a 401(k) for the same year.

The IRS rule is not just about having two plans active on the same day. The prohibition against "maintaining" another plan applies to the entire calendar year (or your business's tax year).

• What this means: If you have funded a 5305-SEP for the year and try to start a 401(k) on July 1st, you have "maintained" both plans in the same year. This violates the terms of the 5305-SEP document, effectively disqualifying the SEP for that year.

• The deduction rule: Because you cannot maintain both plans in the same year, you cannot make deductible contributions to both plans for the same tax year.

Example:

A business sponsors a 5305-SEP. In March 2024, the owner makes a SEP contribution for the 2023 tax year (this is allowed). Then, in July 2024, the business makes a SEP contribution for 2024. In October 2024, the owner starts a 401(k) plan.

This is a violation. The employer maintained both a 5305-SEP and a 401(k) in the 2024 calendar year.  To prevent any compliance issues, the employers should not start a 401(k) plan until 2025.

What your recordkeeper must know

When a SEP provider wishes to establish a new 401(k) plan, it is the plan sponsor's responsibility to determine which type of SEP plan they maintain and advise their 401(k) recordkeeper.

To prevent compliance failures, a 401(k) recordkeeper (like Human Interest) may adopt a conservative operational approach. In these cases, unless the plan sponsor provides a copy of their non-model, prototype SEP document, a recordkeeper may assume the sponsor maintains an IRS Model 5305-SEP.

This default assumption is a crucial safeguard. It protects the plan sponsor from inadvertently violating the 5305-SEP's terms by funding both the SEP and the new 401(k) in the same year, which could disqualify the SEP plan and create significant compliance and tax issues.

How to correctly switch from a 5305-SEP to a 401(k)

To safely move from a 5305-SEP to a 401(k), you must ensure you do not "maintain" (or fund) both plans in the same year.

1. Don’t fund the SEP for the year you start the 401(k) plan: This is the most important step. If you start your 401(k) plan in 2025, you cannot make any SEP contributions for the 2025 plan year. Note: You can still make a SEP contribution in 2025 for the prior 2024 tax year (up until your tax filing deadline) without violating the rule, as the 401(k) was not in existence in 2024.

2. Formally terminate the SEP: While the IRS does not require a formal filing to terminate a SEP, you should notify your financial institution that you are terminating the plan agreement and will no longer be making contributions.

3. Notify your employees: You must inform your employees in writing that the SEP has been discontinued.

What If I have a prototype SEP and a 401(k)?

If you have confirmed that your business uses a prototype SEP document that allows for another qualified plan, you might be able to maintain both plans. You should verify this option is available with your document provider (usually a financial institution). If you do end up sponsoring both plans at the same time, be aware that your employer contributions are subject to a combined deduction limit. You may need to work with an advisor to monitor the combined limits of both plans, as many recordkeepers can only monitor the plan they administer.

• Combined deduction limit: A 401(k) plan (with a profit-sharing component) and a SEP are both considered "defined contribution" plans. Your total, combined employer deduction for contributions to all of these plans (e.g., SEP contributions + 401(k) matching + 401(k) profit sharing) is generally limited to 25% of the total compensation paid to all eligible employees.

While possible, maintaining both a prototype SEP and a 401(k) is complex and offers little advantage, as the 401(k) plan can accomplish the same goals (e.g., employer profit sharing) within a single plan. Most plan sponsors choose to terminate their SEP and use their 401(k) plan exclusively.

Before making any changes to your retirement plan, we strongly urge you to speak with a financial advisor or qualified tax professional to ensure a smooth and compliant transition.