The Individual 401k vs SEP IRA debate has raged for years. That might be a bit of an exaggeration but it’s still a conversation I have with small business owners and their tax professionals. We all want to know what is “best” but most often it’s simply a matter of pros and cons. What is best for one person might not be best for another given the circumstances. To compare apples to apples, we’ll look at these pros and cons assuming the self employed individual has no employees.
The Individual 401k vs SEP IRA debate came about as a result of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA). Up to that point, the SEP IRA had been the go to retirement account for self employed individuals without employees. Even today, I frequently hear people asking if they should open a SEP IRA. This usually occurs when someone starts receiving 1099 income either from a side business or from a new endeavor where they are no longer a common law employee.
Despite the fact that the Individual 401k has been around since 2001 most people think of the SEP IRA first. It’s somewhat like people referring to all soft drinks as a “Coke.” More likely, it is the result of a lack of tax planning. SEP IRAs can be opened at tax time for the prior year unlike 401k plans that need to be opened by 12/31 (more on that later).
Individual 401k vs SEP IRA when you haven’t planned ahead:
After years of frustration working hard to make someone else rich, you go out on your own. You’ve finally taken the leap and joined the ranks of the self employed or self inflicted depending how you look at it. Business is great and you’re busy serving clients and expanding your burgeoning empire. Then, when you finally start doing your taxes in February or March, you realize “I need to reduce my tax bill!” In this case, the SEP IRA wins. It’s not because it’s the best option. It’s your only option. The reason is because it’s too late for an Individual 401k. But fear not. You’re not stuck with the SEP IRA forever.
With a SEP IRA, you can open the account at tax time for the prior year. For example, you’re doing your 2016 taxes in March of 2017. No problem. You can open the SEP IRA, fund the account, and receive a nice tax deduction for 2016. Even for those who file an extension, you can open the SEP IRA in September and still get a deduction for the prior year.
How much can you deduct from the SEP IRA?
The most common number we hear for maximum contributions is 25% of compensation. But there’s a little more to it when we’re dealing with Schedule C income for a sole proprietor, a partner in a partnership, or an LLC. Two adjustments need to be made:
- Schedule C net income needs to be reduced by 1/2 of the self employment tax.
- The plan’s contribution rate is adjusted by the rate table in IRS Publication 560. The short way to make this adjustment is by taking the plan contribution rate of 25% and dividing by 100% + 25%. The adjusted contribution rate is now 20% (25%/125% = 20%)
The chart below provides the allowable contribution and deduction based on various amounts of Schedule C net profit. You will notice that the $265,000 in Schedule C net profit doesn’t get you to the $53,000 annual limit. It results in a $50,821 SEP IRA which is a little over $2,000 short. And so it goes for the self employed (self inflicted). Another kick to the groin! Your Schedule C net profit needs to be at least $276,041 to hit the $53,000 IRS limit.
How much can you contribute to an Individual 401k?
With the Individual 401k, you still need to make the adjustments for Schedule C net profit as you do with the SEP IRA. However, there are two significant differences consider:
- Salary Deferral Contribution: With the Individual 401k, you can contribute $18,000 in salary deferral in addition to the profit sharing contribution. This allows a larger tax deductible contribution than the SEP IRA with same level of income.
- Catch-up Contributions: With the Individual 401k, you are eligible for catch-up contributions if you’re age 50 or older. This provides an additional $6,000 worth of tax deductible contributions with the Individual 401k vs SEP IRA.
Beware of the Individual 401k IRS form 5500-EZ:
Some of the big obstacles to establishing a retirement plan for business owners is the time and costs involved. Individual 401k and SEP IRA plans both make it possible to have a plan that is both low cost and easy to administer. However, if you’re not careful you might be in for a surprise.
Unlike SEP IRAs, traditional 401k plans are required to file a tax form each year known as IRS form 5500 or 5500-SF. Which form you file depends on the size of the plan. These forms require a skilled professional to ensure it is done properly. Most often a pension accountant or third party administrator will prepare this form and help make sure the plan sponsor is complying with the rules and regulations.
Individual 401k plans are exempt from these annual tax filings until they reach $250,000 in assets. Once the individual 401k plan hits this level, you must file the IRS form 5500-EZ. Don’t let the “EZ” part fool you. If you’re not familiar with retirement plan accounting and various IRS rules on the subject, proceed with caution. Even better, consult a professional to assist you with the preparation.
Because most people start out in the Individual 401k plan thinking it will take a few years to hit $250,000, they don’t give much thought to the annual filing requirements. Because many of these plans allow for incoming rollovers from other retirement accounts, this threshold may be reached much sooner that initially anticipated.
Filing these tax forms takes time and money. Failing to file can cost more time and money. The due date is the last day of the seventh month after the plan year ends. For calendar year end, this would be July 31. Don’t assume that your investment provider or custodian is going to file these forms for you. Be sure you know the filing rules and stay off of the IRS’s naughty list.
Individual 401k vs SEP IRA: Roth Contributions
As mentioned above, a big difference between these plans is how they are funded. SEP IRAs are only funded with employer contributions. This is in contrast to the Individual 401k where there are two funding sources:
- Employer profit sharing (up to 25% of compensation)
- Employee salary deferral (up to $18,000 and an additional $6,000 for catch-up)
The dual funding source is what makes the Individual 401k attractive. Less income is needed to fully the account than is needed to fully fund the SEP IRA. This translates to a greater tax deduction.
Because Individual 401k plans allow salary deferrals, they also allow Roth salary contributions. These contributions are made with after tax dollars and are a way to set aside funds that can be distributed tax free in retirement. I cover this information in detail in another article Roth 401k Plans: 5 Things You Need To Know.
Many people are not eligible to make Roth IRA contributions due to their income exceeding the IRS threshold. However, with Individual 401k plans (and Traditional 401k) there is no income limit. This means someone who was excluded from contributing to a Roth IRA can contribute to a Roth 401k.
There are always trade offs. It is important to remember that amounts you contribute via Roth are not deductible. You need to consider whether building a tax free fund for retirement is more important than the immediate tax deduction of traditional contributions. Be sure your individual 401k plan allows them. While Roth contributions are allowed per regulations, not all investment providers allows this provision in their plans so choose carefully.
Individual 401k vs SEP IRA: Loan Provisions
A common feature of 401k plans is the ability to take a loan from your account. Whether it is advisable to take a loan is a separate topic that I address in 401k Loan – 3 Reasons Not To Borrow. Like Roth provisions, you will need to be sure that the financial institution you work with allows loans as part of their individual 401k plan document.
SEP IRAs, in addition to all types of IRAs, do NOT allow loans. They do allow for early distributions that are subject to penalties in addition to regular income taxes. There is a back door way to access funds in an IRA for a short period of time. This is known as the “60 day rule.” As a result of misuse of this rule and court rulings in favor of the IRS, the rules have become more stringent and these transactions are on their radar.
Individual 401k funding deadlines vary depending on source (salary deferral and/or profit sharing) and tax filing status of the business entity (LLC, Sole Prop, C-corp, S-corp, or Partnership).
- Salary deferral and employer profit sharing contribution deadlines for sole proprietorship, Partnerships, and LLCs taxed as a sole proprietorship follow the personal tax filing deadline. This is usually April 15 or later if extensions were filed.
- For C-corps, S-corps, and LLCs taxed as a corporation, the salary deferral deadline is usually December 31st of the year the deduction is intended for. Employer profit sharing contributions are due the following March 15 (plus extensions).
SEP IRA funding deadlines depend on the tax filing status of the business entity.
- Sole proprietorship, partnerships, and LLCs taxed as a sole proprietorship follow the personal tax filing deadline. This is usually April 15 or later if extensions were filed.
- For C-corps, S-corps, and LLCs taxed as a corporation, the deadline is usually March 15 (plus extensions).
While there are many similarities between these retirement accounts, they are very different animals. The Individual 401k offers some attractive advantages but has the potential to lead to greater complexity and cost. The SEP IRA in comparison is much more straightforward but in an effort for simplicity, the SEP IRA might leave one shortchanged. More information can be found about these plans and others here.
It’s not about which one is better. It’s about which one makes sense for you. In either case, these retirement accounts offer substantial tax savings and are much more robust than typical IRA and Roth IRA investments. Don’t get too caught up in the debate. If you’re self employed with no employees and you don’t have either, get started!