Self-Employed? SEP vs. Solo 401(k) (Part 1)

As a self-employed person who wants to self-direct their IRA or 401(k), the question may come up as to whether you should establish a self-directed SEP-IRA or Solo 401(k) plan. Self-directed or not and no offense intended, but most self-employed people after visiting with their CPA or financial planner believe that the SEP-IRA is better.  But is it?  OR, is it perceived as the path of least resistance?   The path of least resistance can sometimes be a great path…but not necessarily if the intended benefits of that path are far lesser.

See, it doesn’t matter to me which path a client takes as I work with clients with both SEPs and 401(k)s clients (far less SEPs by the way), but I am going to take the position that the Solo 401(k) is not only probably better for most self-employed individuals, but also not difficult to administer.  And, even if it was, there are significant benefits of the 401(k) plan that should make most self-employed people run (not walk) away from there SEP to establish the Solo 401(k).  I mean far be it for me to ever debate any tax issue with a CPA, but when people know and truly understand the benefits of the 401(k) over the SEP-IRA, there is really no comparison.

We are going to break out these benefits over several blogs.  I believe that when you understand all the benefits of the Solo 401(k), it will be real difficult to actually elect the SEP over the 401(k).  And, in most people’s minds, what is the primary benefit?

Contribution Limits

Folks this is a numbers game….it either makes sense or it doesn’t.  But, I can’t think of a single client I work with where the contribution limits of the 401(k) is not higher than the SEP.  When many first see the contribution limits of a SEP they believe that the SEP permits just as high as a contribution limit as the 401(k).  And, technically, they are correct….they see that for someone under the age of 50, the SEP permits up to $53,000 and the 401(k) permits up to $53,000.  However, the path in getting to that number is the key.  And, even for those with lower contribution ability (e.g., lower income), they will be able to put in a higher contribution amount with the 401(k) vs. the SEP.  Just think of it this way…you will be able to put more in with less income with the 401(k).

You see, a major difference between the SEP and the 401(k) is that the SEP is simply a profit sharing plan which allows the self-employed person to put in a percentage of income, where the 401(k) permits the self-employed person to contribute an employee “elective deferral” in addition to the business making a profit sharing contribution on behalf of the employee.

Prove It….Let’s Use an Example

Both the SEP and 401(k) are equal in that they both permit the profit sharing contribution.  We will address the profit sharing in a bit.  However, while both the SEP and 401(k) permit profit sharing contributions, the 401(k) has the additional benefit of permitting the participant to make employee elective deferrals into the plan.  In more simplistic terms, think of the elective deferral as that income that the participant is putting in directly from their wages or compensation, separate from the profit sharing contribution.

Elective Deferrals — The SEP does not permit employee elective deferrals…only the 401(k).  For a 401(k) participant under the age of 50, their elective deferral contributions can be up to $18,000 or 100% of their income.  If the 401(k) participant is over the age of 50, the elective deferral contribution can be up to $24,000 or 100% of income.  In addition, these elective deferrals can be made in either a pre-tax or Roth (after-tax) basis.  All contributions to the SEP-IRA must be made in a pre-tax manner.

Profit Sharing — Both the SEP-IRA and 401(k) have the ability to make profit sharing contributions.  With both the SEP and 401(k), these percentages are based on income, but due to the fact that the 401(k) participant has the elective deferral option, they will reach maximum contribution limits with less income.

For both plans, the business profit sharing contribution is up to 25% (or 20% if the business is a sole proprietorship or single member LLC).

The Case of Jim — Jim is over 50 years of age and is a self-employed medical professional with no employees (e.g., common law employees).  His business is established as an S-Corp.  He is paid wages of $100,000.

SEP-IRA — Since the SEP-IRA contribution limit is 25% of compensation as a maximum contribution, Jim could have a total contribution of $25,000 (25% of $100,000 compensation) to the SEP.

SOLO 401(k) — Remember, Jim being over the age of 50 can make employee elective deferrals of $24,000 from his wages.  However, in addition, Jim’s business (again, an incorporated entity) can make a 25% profit sharing contribution of $25,000 (25% of ’s W-2 wages) for Jim’s benefit.  Combining the maximum contribution amount of $24,000 and $25,000, Jim is now able to have a total of $49,000 contributed on his behalf…nearly twice the contribution limit permitted with the SEP-IRA.

And for those of you doing math at home, yes, at some point in time (only for an individual under the age of 50), the individual who has high income levels will reach the maximum amount of $53,000 with the SEP just as they would with the 401(k)….they will just reach it with more income rather than less.  But, as you can see, the ability of the 401(k) participant to max out the contribution limits can be done with less income.  And, of course, someone over the age of 50 will always have the “catch-up contribution” of $6,000 (2015) which the SEP-IRA account owner will not have.

Finally, for those of you who are high income earners and the contribution limits are basically the same….stay tuned for the following blogs that will identify several other benefits to the 401(k) vs. the SEP-IRA.  And, this is keeping in mind EVEN IF the contributions were the same, there will be significant reasons to still consider the 401(k) in a head to head battle comparison.

As always, the information provided is intended to be educational in nature.  It is not intended, nor should it be interpreted as, any form of tax, legal, financial or investment advice.  You must always consult with your respective professional in all such matters.