Individual 401(k) vs. SEP IRA: Which Is Best for You?

Individual 401(k) vs. SEP IRA: Which Is Best for You?

June 17, 2022

Saving for retirement can be hard for anyone. Between work, making time for family and friends, and running errands, it’s hard to find time to learn the ins and outs of retirement. As a self-employed professional, you have even more on your plate, so retirement planning usually ends up near the bottom of the to-do list.

Saving for retirement is going to look different from your traditionally employed peers, but luckily there are many retirement plan options available to small business owners, including individual 401(k) accounts and SEP IRAs. Here’s how to decide which option is right for you.

Individual 401(k)

Also known as a solo 401(k), an individual 401(k) is designed for businesses with only one employee, the business owner. The IRS calls it a one-participant 401(k) and only businesses without employees are eligible. 

Key Benefits

  • Roth accounts: As with other 401(k) plans, the individual 401(k) offers both traditional and Roth accounts. With a traditional account, contributions are made pre-tax and taxes are paid upon withdrawal. Roth 401(k)s, on the other hand, are funded with after-tax dollars but they grow tax-free. This gives you the flexibility to actively choose the contribution style that works best for your specific tax situation. 
  • Employee deferrals: Individual 401(k) plans also allow employee deferrals in addition to the employer contribution. This option is not available with SEP IRAs.
  • Loan provisions: Another benefit of this plan is the ability to take loans against the account balance up to the lesser of 50% of the balance or $50,000. 
  • Higher contribution limits: Individual 401(k) plans have two types of contribution limits. First is the profit-sharing limit for employer contributions, which is the lesser of 25% of business revenue or $61,000. (1) The next limit is the annual employee elective deferral limit, which is $20,500 for individuals under age 50, and $27,000 for those age 50 and older. (2) The combined limit for both employer and employee contributions is still $61,000 (or $67,000 if older than 50), but because there are two types of contributions permitted, most self-employed individuals will be able to contribute more and receive a larger tax break than if they used a SEP IRA.

Drawbacks

  • Strict reporting requirements: If your account balance exceeds $250,000, you will be required to file an annual return with the IRS. The return consists of Form 5500 and can be quite extensive. Even if you don’t have $250,000 in your account, you may be required to file.
  • Only available for businesses with no employees: Individual 401(k)s are only available for businesses with no employees except the owner’s spouse. If you have plans to expand your business and hire additional employees, opening an individual 401(k) is probably not for you. You may be required to convert your plan to a qualified 401(k) and contribute on behalf of your employees if you were to hire any.

SEP IRA

A Simplified Employee Pension (SEP) IRA functions similarly to a traditional IRA, except as the owner, you set up and contribute to accounts for both yourself and your employees.

Key Benefits

  • Tax-deductible contributions: Your contributions are tax-deductible up to 25% of all participants’ compensation, or up to 25% of net earnings if you’re self-employed. (3)
  • Higher contribution limit: In 2022, the contribution limit for a SEP IRA is the lesser of 25% of an employee’s compensation or $61,000. (4) This limit is higher than the limit for tax-advantaged accounts like traditional and Roth IRAs, but as mentioned above, it’s not as high as the limits for individual 401(k) plans.
  • Easy setup & maintenance: SEP IRAs do not require the extensive reporting requirements required by other qualified retirement plans. You are also not responsible for the underlying investments in your employees’ accounts. As the employer, you simply choose the financial institution you want to work with and open the accounts. Beyond that, it is the employees’ responsibility to choose and manage their own investments. Additionally, many financial institutions offer SEP plans with little to no management fees, making this a very inexpensive and attractive option for small business owners.
  • Contributions are discretionary:Contributions to these plans are flexible and discretionary, meaning you can adjust your contributions as your cash flow changes. This ensures that you never contribute more than you bring in.  

Drawbacks

  • Strict eligibility requirements: According to the IRS, all employees must be allowed to participate in the SEP plan if they are age 21 or older, earned at least $650 in 2022, and worked for you for at least 3 of the last 5 years. (5) This can make SEP IRAs an inflexible option for small businesses that want to limit the number of employees in the plan.
  • When you do contribute, you must contribute to everyone: In the years that you contribute to a SEP IRA, you are required to make equal contributions as a percentage of compensation to all eligible employees. For instance, if you contribute 20% of your income to your own SEP IRA, you must then contribute 20% of every employee’s income to their respective accounts. Because of this, SEP IRAs are generally recommended for self-employed individuals or small businesses with very few employees.
  • No loan provisions, Roth accounts, catch-up contributions, or employee deferrals: Many of the benefits offered by individual 401(k)s are not available for SEP IRAs.

Which Choice Is Right for You?

If you are a small business owner or self-employed individual, don’t wait to start saving for retirement. We at Favor Wealth can help you decide which retirement account is right for you and your business. To learn more about your options, contact us at 626-529-0445 or email Ricky directly at info@favorwealth.com

About Ricky

Ricky Biel is founder, wealth manager and Chartered Retirement Planning Counselorâ„  professional at Favor Wealth, an independent financial advisory firm serving individuals and families near Pasadena, California. Ricky Biel founded Favor Wealth with a desire to provide unbiased, client-centered, community-based financial advice. Ricky and his team of caring, smart professionals want their clients to feel like they’ve done them a favor, making it easier than ever to accomplish their financial goals by blending proven investment methodologies with creative financial technologies. He is on a mission to help his family of clients feel both a sense of relief and excitement about their future. Favor Wealth takes care of their clients’ needs first and foremost and goes the extra mile to make their clients’ finances grow. To meet and see how the Favor Wealth team may be able to help, contact them today at 626-529-0445 or email Ricky directly at ricky@favorwealth.com

The commentary on this blog/website reflects the personal opinions, viewpoints and analyses of the Favor Wealth Advisors’ employees providing such comments, and should not be regarded as a description of advisory services provided by Favor Wealth Advisors or performance returns of any Favor Wealth Advisors’ Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Favor Wealth Advisors manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

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(1) https://www.investopedia.com/articles/financial-advisors/012716/solo-401k-vs-sep-which-best-biz-owners.asp
(2) https://www.investopedia.com/articles/financial-advisors/012716/solo-401k-vs-sep-which-best-biz-owners.asp
(3) https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-seps
(4) https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-seps
(5) https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-seps