SEP's and 401k's are qualified retirement plans available to businesses of any size, including those individuals who are self-employed. SEP IRA vs. a 401k? Which is the best plan for your business? The answer to this question depends on a myriad of factors, including the relative administrative costs of a 401k or SEP plan, as well as the purposes for which the business owner is establishing their retirement plan.
SEP IRA vs. 401k
The Simplified Employee Pension plan ("SEP") or SEP IRA, is available to all self-employed individuals and business owners with employees. The employer can contribute up to a maximum of 25% of an employee's salary. Employers who offer the SEP IRA must make contributions to employees who are at least 21 years old, have at least 3 years of service in the last five years, and who have earned at least $450 in compensation from the employer for the year. Contributions are made to each eligible employee’s IRA account.
There is not an employee contribution option in an SEP IRA; contributions are 100% employer funded. The amount of the employer contribution is discretionary: it can increase or decrease at the election of the employer. All employer contributions are immediately 100% vested. IRS regulations also prohibit personal loans taken out against the assets in a SEP IRA. The employer contribution rate, i.e., the percentage of salary contribution must be the same for each employee.
A SEP IRA is easy to establish and simple to administer.
For 2009, the maximum allowable amount of employer contributions to the employee SEP IRA is the lesser of $49,000 or 25% of the employee’s salary. Employer contributions made to an SEP IRA are tax deductible.
401k vs. SEP
401k plans are available to businesses of any size, including those who are self-employed.
The most salient distinguishing feature between a 401k vs. an SEP IRA, is that the 401k allows an employee elective salary contribution option that grows tax-deferred in an investment account until retirement. Taxes are due when withdrawals are made from the account. Employers can match employee contributions at their discretion. In fact, with a 401k, employers can choose to have their contributions subject to a vesting schedule which can help the business retain employees.
Another important distinction between an SEP IRA and a 401k is that due to the way the contribution is calculated, the self-employed individual may be able to make a greater contribution into an Individual 401k versus an SEP IRA at comparable income levels.
For 2009, participants in a 401k can contribute up to a maximum of the first $16,500 ($22,500 if over 50) of W-2 compensation, or net self-employment income for a sole proprietorship. It should be noted that the SEP IRA does not allow the additional $5,500 over 50 "catch-up" contribution so that may be an important distinction depending on your situation.
Since 401k plan providers can also make a profit-sharing contribution of up to 25% of W-2 wages or 20% of net self-employment income, the net maximum allowable contribution could be higher for those business owners with a 401k compared to those with a SEP IRA even for the same income levels. 401k employer contributions are tax deductible.
SEP IRA vs. 401k: Which is the best retirement plan for your business? The answer to that question depends on a number of factors including the business owner's particular objectives. If you’re simply looking to rapidly establish a plan that is easy to administer and has low overhead, then the either plan is suitable. Both plans can have offer good investment choices but that selection ultimately depends on the company you select for plan administration.
However, if you want to maximize the amount of your allowable contributions, as well as valuable tax deductions, a 401k plan may be the more appropriate vehicle. Additionally, the fact that an SEP IRA allows no employee salary deferral contributions may be a drawback from the standpoint of hiring and retaining competent employees.
Finally, the ability to take a tax-free loan against 50% of the plan's value with a $50,000 maximum is a clear advantage for those small and start-up businesses that may need funds for cash flow or other unanticipated business needs in the future.
