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

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

| December 01, 2022
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You have a lot of freedom and options when you’re self-employed. And since you know you need to make saving for retirement on your own a priority, you want to know which retirement plan will work best for you.

So which do you choose?

Let’s compare 401(k) and SEP IRA plans so you can determine the plan that will best suit your unique needs.

Individual 401(k)

Also known as a solo 401(k), an individual 401(k) is designed for business forms 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 $66,000 for 2023. The next limit is the annual employee elective deferral limit, which is $22,500 for individuals under age 50, and $30,000 for those age 50 and older. The combined limit for both employer and employee contributions is still $66,000 ($73,500 including catch-up contributions), 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 it 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

  • Higher contribution limit: In 2023, the contribution limit for a SEP IRA is the lesser of 25% of an employee’s compensation or $66,000. 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 you 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 you’re never contributing more than you’re bringing 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 (or $750 in 2023), and worked for you for at least 3 of the last 5 years. 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 Plan Is Right for You?

Are you self-employed and in need of a little financial guidance? I would love the opportunity to help you determine which retirement plan is right for you and your business. 

Schedule an introductory meeting online or reach out to me at (770) 627-4157 or Garrett@MyHorizonPG.com to get started. 

About Garrett

Garrett L. Holcombe is president at Horizon Planning Group, a full-service fiduciary financial planning firm committed to always doing what’s right for their clients. With over a decade of experience, Garrett specializes in serving small business owners, giving them a step-by-step process to help them overcome the challenges they face every day and take advantage of the opportunities available to them. His vast knowledge and dedication to his clients allows him to tailor a plan to his clients’ needs and goals, whether that’s creating a start-up plan, financing and tax strategies, employee benefits, and more—all so that his business owner clients can experience confidence in their financial future. Garrett is known for his passion for education. He takes on the role of a teacher so he can help his clients feel empowered about their decisions and understand their financial situation thoroughly. He wants his clients to know that he’s always there for them, no matter what their questions or concerns are, and is always working behind the scenes to keep your plan moving forward. 

Garrett graduated from Kennesaw State University with a bachelor’s degree in political science and is a CERTIFIED FINANCIAL PLANNER™ professional. When he’s not serving his clients, Garrett loves spending time with his wife, Amber, and their two children, Samantha and Matthew. Garrett and Amber were one of the first foster homes with Goshen Homes, a foster care agency of Goshen Valley that specializes in keeping siblings together. They adopted their children through the foster care program. Garrett is heavily involved in his community, serving as an adult leader and the safety and training officer for Sea Scout Ship Southwinds 100, and is president of the Cherokee High School Band of Warriors Booster Club. He is part of the Woodstock Business Cub and an active member of his church. In his downtime, he loves cheering for the Braves and Georgia Bulldogs and is an avid Liverpool Football Club and Atlanta United fan. To learn more about Garrett, connect with him on LinkedIn.

This is for educational and informational purposes only and is not research or a recommendation regarding any security or investment strategy. 

The information given herein is taken from sources that IFP Advisors, LLC, dba Independent Financial Partners (IFP), IFP Securities LLC, dba Independent Financial Partners (IFP), and its advisors believe to be reliable, but it is not guaranteed by us as to accuracy or completeness. This is for informational purposes only and in no event should be construed as an offer to sell or solicitation of an offer to buy any securities or products. Please consult your tax and/or legal advisor before implementing any tax and/or legal related strategies mentioned in this publication as IFP does not provide tax and/or legal advice. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. This report may not be reproduced, distributed, or published by any person for any purpose without IFP’s express prior written consent.

Securities offered through IFP Securities, LLC, dba Independent Financial Partners (IFP), member FINRA/SIPC. Investment advice offered through IFP Advisors, LLC, dba Independent Financial Partners (IFP), a Registered Investment Advisor. IFP and Horizon Planning Group, Inc. are not affiliated.

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