401(k) vs. SEP IRA: These Experts Offer Tips on Which to Choose

If you’re about to start your own business or have recently done so, you’ve likely wondered what retirement plan might be best for you.

Is it a 401(k) plan? A SEP IRA? Something else?

With the many options available, I asked four financial advisors for their thoughts on the two most popular options, 401(k) plans, and SEP IRAs.

Other options (outside the scope of this article) include the SIMPLE IRA and SIMPLE 401(k).

Who Are the Pros?

Here are the four advisors:

• Chris Mankoff, CFP®, JTL Wealth Partners
• Jenna VanLeeuwen, CFP®, Financial Planner for Business Owners, Principal at Aligning Wealth
• Michael R. Acosta, CFP®, ChFC®, Financial Planner at Consolidated Planning
• Stanley Himeno-Okamoto, CFA, CFP®, founder of DRS Financial Partners

Before we dive in, let’s start with a brief definition and description of a SEP IRA. According to the Internal Revenue Service (IRS), a SEP-IRA account is a traditional IRA and follows the same investment, distribution, and rollover rules as traditional IRAs. A Simplified Employee Pension (SEP) plan provides business owners with a simplified method to contribute toward their employees’ retirement as well as their own retirement savings. Contributions are made to an Individual Retirement Account, or Annuity (IRA) set up for each plan participant (a SEP-IRA).

Pros and Cons of 401(k) Plans for Solopreneurs

If you’re self-employed and have no employees (beyond perhaps your spouse), you can establish a simple yet powerful retirement plan – the Individual 401(k), interchangeably referred to as a Solo 401(k), or Solo-K for short.

Stanley Himeno-Okamoto explains, “An Individual 401(k) is a special kind of 401(k) with fewer reporting requirements, administrative burdens, and ERISA rules to follow.”

Chriss Mankoff lists a slew of benefits:

• “Your employee contributions reduce your adjusted gross income
• “The plan allows a maximum contribution of $20,500 in 2022, with a catch-up contribution of $6,500 allowed for individuals over the age of 50, for a total contribution of $27,000
• “Roth contributions are permitted, allowing a maximum contribution of $20,500 in 2022 ($27,000 for individuals over the age of 50)
• “Due to ERISA protection, 401k plans are generally protected from creditors, bankruptcy proceedings, and civil lawsuits
• “Loans are permitted within 401(k) plans
• “Enables individuals to roll over pre-tax funds from existing IRAs into the individual 401(k) to execute backdoor Roth conversion strategies
• “Provides employers with tax deductions and payroll tax savings”

Mankoff then elaborates on the Roth option, “This is a great way for individuals to make Roth contributions that aren’t subject to annual income limits. For example, an unmarried individual earning over $144,000 in 2022 wouldn’t be allowed to contribute to a Roth IRA due to the income phaseout limit. That same individual could contribute to a Roth 401(k) the 2022 maximum of $20,500 if they’re under 50 or $27,000 if they’re 50 or older.”

Michael Acosta chimes in on using such a Roth option, “The bet here [in using the Roth option] is whether it makes more sense to pay the taxes upfront today based on today’s effective tax rate knowing your assets will grow to be tax-free at the time of distribution.”

Acosta continues, explaining the maximum contribution breakdown, “The Solo-K also allows contributions to be made as both ‘employee’ and ‘employer’ by way of profit-sharing. For example, a business owner with a Solo-K can defer as much as $61,000 in a given year ($67,500 if they’re 50 or older). This is broken down as a max ‘employee’ contribution of $20,500 ($27,000 for 50 or older) and $40,500 in profit-sharing.”

Speaking about the 401(k) loan option, Acosta says, “Another benefit for the Solo-K is a loan provision equal to the lesser of 50 percent of the plan balance or $50,000. This is just another layer of flexibility from a planning perspective.”

Jenna VanLeeuwen adds, “An individual 401(k) is a fantastic choice for self-employed individuals. With an individual 401(k) can contribute to the 401(k) based on the first dollars of profit. This means you can contribute to the 401(k) no matter how big or small your business.”

Nothing is perfect, so there are disadvantages to the Individual 401(k) too.

Jenna VanLeeuwen says, “One disadvantage is that to set up an individual 401(k), you need to establish the plan by December 31^st. You can fund the account later, but you do need to have established the plan. With a SEP IRA, for example, you can open and fund the account at tax time. There also can be a bit more paperwork with an individual 401(k). If your account has over $250,000 in assets as of December 31^st, you have to file Form 5500-EZ no later than July 31^st of the following year.”

Stanley Himeno-Okamoto adds, “Many so-called ‘prototype’ (boilerplate) plans at major custodians don’t allow some of the nice-to-haves like the Roth option, in-plan loans, or some other flexibilities. To get all of these, you may need to establish a customized plan.

“The biggest downside of an Individual 401(k) is that if you ever hire full-time employees (other than your spouse), you can’t continue using the Individual 401(k). Not a problem for business owners who want to stay solo or rely only on part-time employees and contractors, but a potential headache for business owners who want to scale.”

Mankoff rounds out the drawbacks:

• “Employer contributions aren’t eligible for the Roth 401(k) portion of the plan
• “Plan costs can vary. Typical expenses associated with a 401(k) plan can be upfront fees to establish the plan, as well as ongoing administration fees, investment fees, and in some cases, services fees for loans or hardship withdrawals. The good news is that the SECURE ACT provides a tax credit for startup costs which may offset startup costs.
• “Calculating profit-sharing contributions for sole proprietorships and partnerships tend to be complex because it requires modified net profits.”

Pros and Cons of SEP IRAs for Solopreneurs

The other most popular plan for self-employed individuals is the SEP IRA.

Acosta kicks off the advantages of these, “You’re unlikely to find a simpler retirement plan to set up. The SEP IRA has been around for decades and is purely a profit-sharing plan that lets a business owner make contributions on their own accord.”

VanLeeuwen adds, “SEP IRAs are simple to set up, and even better, you can wait until you file your tax return to establish and fund the plan. This means that if you file an extension, you can wait all the way until October of the following year. If you are a last-minute saver, that’s a great option!”

Mankoff lists several more benefits of the SEP IRA:

• “Doesn’t have start-up or operating costs.
• “If a business owner expects to hire new employees, a SEP IRA will cover the owner and employees.
• “For businesses that experience inconsistent cash flows, the employer’s contribution amounts can be adjusted accordingly.”

Acosta then lists the SEP IRA’s disadvantages, “The SEP IRA contribution limits are the lesser of up to 25 percent of business revenue (20 percent of net self-employment earnings for sole proprietors) and $61,000 (for 2022). This is lower than a Solo-K may allow. Keep in mind that with the SEP IRA, there’s no catch-up provision for those age 50 or older, which somewhat hinders one’s ability to save aggressively for retirement.

“A major disadvantage, in my opinion, is that the SEP IRA does not offer a Roth option, so it’s solely limited to traditional pre-tax contributions.

“Also, SEP IRAs don’t have loan provisions. This may not be a big deal for a self-employed business owner, but having that option could be handy in a financial emergency.”

Jenna VanLeeuwen adds, “A SEP IRA is an IRA, meaning that rules regarding converting assets from pre-tax to Roth apply, limiting the usefulness of strategies like backdoor Roth conversions.”

Mankoff again rounds up several more drawbacks:

• SEP IRAs are not ERISA qualified, so depending on individual state guidelines, assets in non-qualified ERISA accounts may be subject to creditors.
• Contributions must be the same percentage of compensation for each employee.
• If an employee leaves before the end of the plan term, contributions must still be made to their SEP account, even if they already left the employer

401(k) Pros and Cons for Companies with Employees

This time, we’ll start with the main drawback.

Himeno-Okamoto says, “When employees are involved, things get more complicated. The Individual 401(k) becomes unavailable, and if you want to use a 401(k), it must be a standard 401(k) plan. With that comes more reporting and administration and a legal burden as well. 401(k) plans are covered by ERISA, which protects employees by compelling plan sponsors and managers to adhere to a fiduciary standard.”

Now, let’s move on to the advantages…

Acosta lists several important benefits, “A lot of the same factors echoed above carry over for 401(k) plans with multiple employees. The standard 401(k) plan still offers the flexibility of both traditional pre-tax and Roth contributions.

“The SECURE Act offers business owners tax credits for installing an employer-sponsored 401(k) plan. The increased credits are for the first three years of the plan and offer $500 or, if greater, $250 for each non-highly compensated eligible employee up to a maximum of $5,000. These can be used to cover 50 percent of out-of-pocket expenses for setting up the plan.

“The business owner can establish eligibility requirements such as requiring participants to be age 21 or older, be full-time employees based on the definition of the firm, have at least a year of service at the company, and work a minimum of 1,000 hours. This helps reduce some costs for the plan by having low turnover within the plan and incentivizing employees to stay with the firm for at least a year. The plan can also be set up with a vesting schedule that incentivizes employees to stay long-term, which should benefit the business. For example, a match or profit-sharing offered by the business on behalf of the employee can go through a five-year vesting schedule where in the first year, 20 percent of the match is vested, 40 percent in year 2, 60 percent in year 3, and so on. Basically, should the employee leave early, they’re only allowed to roll over what is vested.”

SEP IRA Pros and Cons for Companies with Employees

Starting with the benefits, Himeno-Okamoto says, “SEP IRAs stay simple by requiring that all eligible employees get the same percentage of salary contributed. If you, as the business owner, want to max out at 25 percent, all your eligible employees must get 25 percent of their salaries contributed. The upside of this simplicity is a massive reduction in reporting requirements and administrative burden. Once the contribution is made, your role is done. It’s up to your employees to make investment decisions and act prudently.”

VanLeeuwen agrees, “With a SEP IRA, all accounts from the business owners to all the employees must be funded according to the same percentage.” However, she then points out, “It’s a great way to help employees save for retirement, but it can be costly as a business owner.”

Acosta adds more drawbacks, “Here too, as in the case of a solopreneur, there’s less flexibility with the plan design, there’s no option for a Roth, and there’s no catch-up contribution which is a meaningful disadvantage when it comes to aggressively saving for retirement.”

The Bottom Line

Acosta summarizes, “The Solo-k and 401(k) is more advantageous for most successful businesses in my opinion. Business owners should work with their financial planners and tax professionals to determine if revenues are high enough to support the contributions limits of the 401k plan vs. the SEP IRA.

“If the business owner is planning to grow their workforce, they may not want to go the SEP IRA route unless they’re willing to make the same contribution percentage for each eligible participant. Lastly, be sure to weigh the upfront costs and ongoing fees. Yes, the 401(k) option has a larger upfront cost for setup, but long-term, there are greater savings opportunities.”

Speaking to solopreneurs, VanLeeuwen suggests considering a completely different option, “If a small business owner doesn’t have any employees, he or she should consider a defined-benefit plan. With such plans, you create a pension for yourself. This lets you save $100,000+ a year. This plan does have some administrative costs, and contributions aren’t optional, but if you have consistent cash flow and high income, it’s an amazing way to save for retirement.”

Additional Articles for Small Business Owners

• Exit Planning for Your Business
• The QSBS Exemption Tax Benefit (IRC Section 1202)

Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.