SEP IRA or Individual 401(k)? A Question Worth Exploring for the Self-Employed
By Jeffrey Abadie, CFP®
April 29, 2024
Choosing between a SEP IRA (Simplified Employee Pension Individual Retirement Account) and an Individual 401(k)—also known as a Solo 401(k) or Self-Employed 401(k)—is an important decision for self-employed individuals or small business owners planning for retirement. Each option offers compelling benefits and considerations, and the choice largely depends on factors such as income, contribution limits, and expected future business growth.
Firstly, let’s explore the SEP IRA. This retirement account is an attractive option for self-employed individuals or small business owners with employees who want a simple and straightforward retirement savings vehicle. With a SEP IRA, contributions are made solely by the employer, and the contribution limit is generous, currently up to 25% of compensation or $69,000 (for 2024), whichever is less. This high contribution limit allows for significant potential retirement savings accumulation, making it an appealing choice for those with stable incomes and business profits. Additionally, SEP IRAs are easy to establish and maintain, with minimal administrative responsibilities and low fees.
Alternatively, the Individual 401(k) offers its own benefits, particularly for individuals (without employees) striving to maximize their retirement savings possibilities. Unlike the SEP IRA, the Individual 401(k) allows the sole participant to contribute as both an employer (25% of compensation) and as an employee ($23,000 in 2024). This dual contribution structure often allows for higher contribution limits compared to the SEP IRA, especially for those with lower income and for those over 50 years of age. Like the SEP IRA, the maximum contribution is also $69,000 (for 2024), but with an additional $7,500 catch-up contribution for individuals aged 50 and older that isn’t allowed with a SEP. What is also appealing is the ability to contribute up to 100% of your earned income to those limits. However, there are additional considerations that could make the Individual 401(k) less appealing or unworkable for your particular situation. Individual 401(k)s are not available for businesses with employees (except a spouse) and the IRS will require an annual Form 5500-SF to be filed. The IRS also requires that contributions need to be recurring and substantial, so utilizing a tax advisor is advised when opting for the Individual 401(k).
The decision between a SEP IRA and an Individual 401(k) often boils down to a few key considerations. For individuals with high and relatively stable incomes, a SEP IRA may be a suitable choice due to its simplicity and high contribution limits based on a percentage of compensation. Conversely, those seeking to maximize their retirement savings with lower or variable annual income may find the Individual 401(k) more advantageous. Consulting with a financial advisor and a tax professional can provide valuable insight into the best retirement savings strategy based on individual needs and objectives. Ultimately, both types of retirement accounts offer attractive features and can serve as effective tools for building a secure financial future in retirement.
Sources:
www.apnews.com/buyline-personal-finance/article/sep-ira-vs-solo-401-k
www.irs.gov/retirement-plans/one-participant-401k-plans
www.irs.gov/retirement-plans/plan-sponsor/simplified-employee-pension-plan-sep
www.journalofaccountancy.com/news/2024/feb/helping-sole-proprietors-choose-between-a-solo-401-k-and-a-sep-ira.html
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