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

As a small business owner, you have so much on your mind as it is. You’re responsible for the financial stability of the organization while managing a wide range of complex issues—it’s no wonder retirement planning may get pushed to the side. 

Even if you’ve found time to research options, you may have noticed it can be difficult to sort through all the information out there and truly know what’s best for you and your business. 

Luckily, it doesn’t have to be that way. There are many retirement plan options available to business owners, including individual 401(k) accounts, SEP IRAs, and even cash balance plans. Here is how to decide which option is right for you.

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 and qualified withdrawals are 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 (up from $61,000 for 2022). 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 (up from $20,500 and $27,000, respectively, for 2022). The combined limit for both employer and employee contributions is $66,000 (or $73,500 if older than 50), 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, which 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

• Tax-deductible contributions: Your contributions are tax-deductible up to 25% of all participants’ compensation, or up to 25% of net earnings if you’re self-employed.
• 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 (up from $61,000 in 2022). 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 include the extensive reporting requirements of 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’s 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: With flexible and discretionary plan contributions, you can adjust your contributions as your cash flow changes. This means 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 $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 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.

Cash Balance Plan

If you’re looking for features of both a 401(k) plan and a defined benefit (DB) plan, a cash balance plan may be a good alternative. A cash balance plan is commonly referred to as a hybrid plan because it offers a guaranteed retirement benefit like a DB plan, but the benefit amount is determined by a stated account balance at the time of retirement, rather than a stated retirement benefit amount. 

Cash balance plans operate more like a defined contribution plan, with individual account balances and annual contributions made by the employer. They can be designed to meet the specific needs of the employer and their employees and can also be combined with a 401(k) to maximize savings even more. However, while a cash balance plan offers more flexibility than a traditional defined benefit plan, it is still more restrictive than a 401(k) plan on its own. I’ll be writing an in-depth article about Cash Balance Plans early next year.

Because every situation is different, it’s important to evaluate each option based on factors such as cost, contribution limits, benefit structure, and administrative complexity.

Which Plan Is Right for You?

The fact is that choosing the right retirement plan requires careful consideration of your unique circumstances and objectives. At Wealth Advocate Group, we advocate for what is most important to you. With financial education, meticulous planning, and clear guidance for your family, we can help you decide which retirement plan is best suited for you and your business.

Call 440-505-5704 or email jbrown@Wadvocate.com to schedule an appointment and find out if we’re a good fit to partner with you on your journey to a comfortable retirement. 

About John

John Brown is a wealth advisor at Wealth Advocate Group, LLC, an independent, fee-based wealth management company. With over 10 years of experience in the financial industry and a background in accounting, John provides sophisticated and specialized services to his senior executive clients who need the expertise of someone well-versed in concentrated securities and restricted stock strategies, as well as the risk and tax burdens that come along with their compensation. John has a bachelor’s degree in accounting and financial management from Hillsdale College and is a CERTIFIED FINANCIAL PLANNER® professional. John is known for his thorough approach, often asking questions and bringing up details his clients have not considered. He strives to address every piece of his clients’ financial picture to make sure they are on the path toward their goals and financial confidence. In his spare time, John and his wife, Christina, enjoy traveling and staying active. You can often find him spending quality time with his friends and family. To learn more about John, connect with him on LinkedIn.

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