Self-employed people can feel like they’re at a disadvantage when it comes to saving for retirement. Without an employer-sponsored retirement plan, it’s up to you to open a retirement account and put money away.
For that reason, many small business owners wait until the business is consistently earning healthy profits to start saving for retirement. But that delay can be costly. Due to the power of compound interest, just one or two years of missed savings can mean your nest egg is tens of thousands of dollars smaller once you reach retirement age.
Fortunately, small business owners have a few options to save for the future. In this article, we will compare two of those options, the SEP-IRA vs. 401(k) to help you determine the best choice for you.
SEP-IRA vs. 401(k): An Overview
SEP-IRAs and 401(k)s both offer tax advantages and higher contribution limits than your standard Individual Retirement Account (IRA). However, they work differently, so they benefit different types of companies, depending on whether you have employees and how much you want to contribute.
A Simplified Employee Pension Plan (SEP-IRA) is an IRA for freelancers, self-employed people, and small business owners. These accounts allow small business owners to save money for retirement for themselves and their employees.
The benefits of a SEP IRA include:
- Lower start-up and administration costs than 401(k)s
- Available to businesses of any size
- Employees are always 100% vested in their account balance
- Flexible annual contribution amounts (good for years with tight cash flow)
There is a downside, though. If you choose the SEP-IRA, you must contribute a uniform amount to all employees’ accounts—including your own. You can contribute up to 25% of the employee’s pay (capped at $66,000 for 2023). So if you want to contribute 25% to your account, you must contribute the same percentage to each employee’s account.
To be eligible to participate in a SEP-IRA, your employees must meet the following requirements:
- Be at least 21 years old
- Have worked for the company at least three of the last five years
- Earn at least $750 in compensation in the 2023 tax year
As the employer, you can set less restrictive participation requirements but not more restrictive ones. For example, you can’t exclude employees until age 25 or increase the time they must be at your company. But you can open the program to younger employees or someone that has worked for you for only one year.
The employer’s contribution to the SEP is tax deductible. All contributions come from the employer—employees can’t contribute to their own accounts. This can be a downside for employees who wish to defer part of their salary for retirement.
Another negative is you are unable to do a backdoor Roth contribution if you have a SEP IRA with a balance in it at the end of the year. This is due to the pro-rata rules established by the IRS.
Under the pro-rata rules, when the IRS calculates the tax due on your backdoor Roth conversion, it bundles all your IRA accounts as one. Then your tax is calculated proportionally based on the fraction of after-tax versus before-tax contributions.
For example, say you have three IRAs, and 80% of the funds within those three accounts are pre-tax and the remaining 20% have already been taxed. If you want to convert 20% of your funds into a Roth IRA, you might think you can claim that you’re transferring the 20% you’ve already paid taxes on so you don’t owe any additional taxes. However, due to the pro-rata rule, 80% of the conversion is subject to taxes, regardless of which account the money comes from.
Finally, you are not able to have a Roth SEP IRA. All contributions must be pre-tax.
John owns a business with ten employees. He wants to provide them with retirement benefits to reduce turnover and attract new talent. John already has ample savings, so he isn’t concerned about contributing aggressively for himself.
He opens a SEP-IRA and contributes an equal percentage of his business income to each employee’s account. He sets requirements that employees must be 21 years old, have been at the company for two years, and have earned at least $750 in the year they qualify.
Adding a SEP-IRA makes John’s business more desirable for employees eager to start saving for retirement but may not have the income to begin on their own.
A 401(k) is a defined contribution plan that allows employees to set aside pre-tax dollars for retirement, but the employer may contribute to the employee’s accounts as well. There are a few types of 401(k) ‘s you can choose to offer.
A traditional 401(k) is sponsored by the business owner. Employees can choose how much they want to contribute, up to an annual limit ($22,500 for the 2023 tax year). The employer can match up to a certain percentage, contribute a percentage of an employee’s salary, or both. A traditional 401(k) allows the employer flexibility to change the percentage of the employee’s salary they match each year as needed.
Employers can also set vesting requirements. While employees are always 100% vested in their own contributions, they may have to work for the company for a number of years—usually up to six years—to be fully vested in the employer-contributed portion of their account.
With a Simple 401(k), employees can defer some of their compensation (up to $15,500 in 2023). But employers must make either:
- A matching contribution of up to 3% of each employee’s pay, or
- A non-elective contribution of 2% of each eligible employee’s pay.
Simple 401(k)s are typically less expensive for small business owners than a traditional 401(k), but they’re only available to businesses with 100 or fewer employees.
A Solo 401(k) is only for business owners with no employees other than themselves and possibly their spouse. It has the same benefits as a traditional 401(k), including pre-tax contributions and tax-deferred growth.
Like a traditional 401(k), you can contribute up to $22,500 in 2023, but there’s another great benefit. Because you’re the employer, you can also contribute up to 25% of your net earnings from self-employment, up to a total contribution of $66,000 in 2023.
You can also contribute an additional $7,500 as catch-up contributions if you’re over 50.
Sophia owns a business that she runs with her husband. She has yet to save for retirement, so she wants to save aggressively to catch up for the time she lost while building the business.
With a Solo 401(k), she can contribute as much as $66,000 per year, which will help her reach her retirement goals, despite starting late. Sophia can also deduct the contributions from her taxable income, reducing tax liabilities while the money grows tax deferred.
Advantages of Choosing a SEP-IRA
Here are a couple of reasons you might choose a SEP-IRA over a 401(k):
- You can use this option even if your business is a side hustle. A SEP-IRA is an option for freelancers and those working a side hustle because you can save for retirement and take advantage of a traditional 401(k) offered by your employer. This can make saving more money for retirement easier and more accessible.
- Contributions aren’t required. The SEP-IRA allows you to save for your or your employees’ retirement, but you don’t have to contribute if you’re having a bad year. You can suspend contributions until revenue or cash flow improves, which can be helpful in challenging situations.
Advantages of Choosing a 401(k)
Here are a couple of reasons you might choose a 401(k) over a SEP-IRA:
- You can save a larger percentage of your income. A SEP-IRA limits you to contributions equal to 25% of your income, which may not be enough depending on your income. On the other hand, the 401(k) allows up to 100% of your income as contributions up to the annual limit.
- You can convert a 401(k) to a Roth. If you want tax-free growth, you can convert your 401(k) to a Roth IRA, paying the applicable taxes now and allowing your retirement funds to grow tax-free and come out tax free at retirement.
- You can make catch-up contributions. If you’ve waited to save for retirement or want to contribute more, you can make catch-up contributions of up to $7,500 per year after age 50.
How to Choose the Right Retirement Account for Your Business
The right retirement account for you and your business depends on your unique situation. Typically, it comes down to your income and the maximum contributions you’re looking to make. On one hand, the 401(k) has a higher contribution limit but has more restrictions, higher costs for setup and administration, and requires you to file an annual tax return (Form 5500) for the plan.
On the other hand, the SEP-IRA has lower contribution limits but fewer restrictions. However, if you have employees, you must contribute the same percentage to their retirement accounts as your own.
Ultimately, the best retirement plan option for you comes down to your individual preferences and goals. We hope this blog post has provided a basic understanding of SEP-IRAs and 401(k)s to help inform your decision, but if you have any further questions about these plans or would like more information specific to your situation, please reach out. Taking the time to assess which plan is right for you can make all the difference in developing a secure retirement account that works for you and your business’s needs.