SEP IRA vs 401(k) for Self-Employed Individuals

LAST REVIEWED Oct 29 2020 8 MIN READ

By The Human Interest Team

If you’re self-employed or a small business owner, you’ll need to make plans for your retirement. While you can usually expect a retirement plan to be already in place if you work for an employer, you’ll be responsible for setting one up if you work for yourself. Even putting a small amount regularly into an Individual Retirement Account (IRA) can help boost your savings for your retirement. But because the annual limit for a traditional IRA is $6,000 ($7,000 if you’re age 50 or older), you may want to look at other options to help you save more.

There are two main types of retirement plans you might want to consider if you’re self-employed or a small business owner: a SEP IRA and a 401(k). In this article, we’ll look at both options’ features, their pros and cons, eligibility criteria, and how you can invest your money.

What Is a SEP IRA?

A Simplified Employee Plan (SEP) IRA is an IRA designed to meet the needs of people who are self-employed or running small businesses. With a SEP IRA, you can set part of your earnings aside for your retirement while also reducing your overall tax bill.

Common features of a SEP IRA include:

  • Payments into your SEP IRA are considered business expenses.

  • Only employer contributions can be made to a SEP IRA.

  • A maximum of 25% of your compensation can be paid into a SEP IRA.

  • The cap for SEP IRA contributions is currently $57,000 per year

  • The investments you can choose from are usually the same as if you have a standard IRA.

If you have several employees at your company, you might find a SEP IRA to be an expensive option, because you must match any contributions you make yourself for every employee.

What Is a Solo 401(k)?

A solo 401(k) is also sometimes called an individual 401(k). It’s an ideal option if you want to enable both employer and employee contributions into your retirement plan.

Common features of a solo 401(k) include:

  • The plan is only available to business owners, their partners, and spouses.

  • The 401(k) can be funded with employee salary deferrals and employer profit-sharing payments.

  • The total employee and employer contributions cannot be more than $57,000 per year.

  • The balance of your 401(k) will grow tax-free.

  • The contributions you make to the 401(k) are on a pre-tax basis.

Most banks and online brokerage services offer solo 401(k) products. All you’ll need to apply for one is your employer identification number.

Choosing a SEP IRA vs 401(k)

Both plans are worth considering if you’re self-employed or running a small business.

Because SEP IRAs have high contribution limits, you’ll be able to make significant savings when calculating your business taxes by deducting your contributions. There’s also less paperwork associated with a SEP vs 401(k).

You can continue funding your SEP IRA until you file your taxes, including any extensions from the previous year.

There are some drawbacks to choosing a SEP IRA, however. First, you can’t take any loans from a SEP IRA. If you withdraw funds from it before you’re 59 1/2, you’ll have to pay a 10% early withdrawal fee. Additionally, you’ll be taxed at the relevant income tax rate on your withdrawal. Finally, you have to start accepting Required Minimum Distributions (RMDs) when you’re 72 years of age (increased from 70 1/2 after the SECURE Act). The government taxes these RMDs.

A solo 401(k) might be a good choice if you want to save more than $6,000 per year, which is the limit for traditional IRAs. In addition to making contributions as both an employee and employer, you can double your contributions if your spouse gets an income from your business. Employee and employer contributions can usually be made to your 401(k) until your tax filing deadline. However, It’s worth checking with your provider to make sure this is the case.

Unlike SEP IRAs, you can take a loan from a 401(k). The terms on this vary, however, so check with your provider to make sure it allows loans.

In many cases, you can also benefit from a Roth option, which involves paying into your 401(k) using post-tax rather than pre-tax dollars. You’ll benefit from this when you make withdrawals from your 401(k) because they’ll be tax-free.

Eligibility Requirements for a SEP IRA

The IRS sets several eligibility requirements for someone to obtain a SEP IRA. They include:

  • The person must be at least 21 years old.

  • They must have worked for you for three of the past five years.

  • They received at least $600 in income from you in the past year.

Requirements for a 401(k)

If you wish to open an individual 401(k), you’ll need to:

  • Fill out an application form and sign a plan adoption agreement.

  • Fill out IRS form 5500-SF if your account balance is higher than $250,000.

  • Limit employee salary deferrals to $19,500 per year, plus an additional $6,500 if you’re 50 or over.

Investing Your Retirement Savings

Whether you opt for a SEP IRA or a 401(k) plan, you’ll have many of the same investment options. Most SEP IRA providers will allow you to create your own portfolio, which can include several types of investments. These include:

  • Mutual funds.

  • Bonds.

  • Stocks.

  • Exchange-Traded Funds (ETF).

  • Target Date Funds (TDF).

For individual 401(k) accounts, you’ll generally have the same investment options to choose from. However, bear in mind that some financial institutions restrict the types of investment 401(k) customers can make. Therefore, you may want to compare several providers before opening your account to see which one suits your needs best.

If you’re running your own business and find you just don’t have the time to spend researching your retirement savings options, consider hiring a financial adviser to help. These trained professionals can explain your options in a straightforward way and recommend the best choices for your particular situation.

We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment advising, and integration with leading payroll providers.

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