SEP IRA vs. 401(k) Profit Sharing Plan

SEP IRA vs. 401(k) Profit Sharing Plan

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SEP IRA or 401(k) Profit Sharing Plan

Which Should You Choose?

The Simplified Employee Pension Plan (“SEP”) IRA and the 401(k) Profit Sharing Plan (401(k) PS) are two of the most common retirement plans for successful small businesses and self-employed individuals, since they offer high contribution limits and flexible annual contributions. But which is right for you—the SEP or 401(k) PS? That depends on how much you want to shelter on a tax-deductible basis for retirement each year.

Simply put: the 401(k) PS allows greater retirement contributions, but it usually involves greater administrative responsibilities and higher fees than a SEP. The SEP is easier to set up and more flexible.

Features of a SEP

The SEP is a great choice for self-employed people and small businesses who want to contribute up to 25% of their W-2 earnings or 20% of net income up to the contribution limit.

This type of plan also has the optional flexibility to allow you to convert to a regular Roth immediately or anytime in the future. Here are some additional features of a SEP plan:

  1. Part-time employees must be included
  2. All employer contributions are 100% vested immediately
  3. Assets are not protected from creditors
  4. Loans are not allowed
  5. Employer contributions only

Features of a 401(k) Profit Sharing Plan

A 401(k) PS plan offers four primary advantages over the SEP:

  1. Employees who work less than 500 hours can be excluded
  2. You can set up a six-year vesting schedule e.g: 0-20%-40%-60%-80%-100%
  3. Assets are protected from creditors
  4. Loans are permitted up to 50% of the total 401(k) PS value with a $50,000 maximum
  5. Potentially greater retirement contributions at the same income level

Contributions are flexible for either program. You can make them in some years and not in others.

The term “Profit Sharing” is actually a misnomer. It is not based on profit but on compensation (salary). In fact, you can have a net loss on the corporation and still make profit sharing contributions.

Example:

Owner pays themself $125,000 salary

  • The contribution to a SEP:
    25% of $125,000 = $31,250 (paid by corporation)
    Total contribution: $31,250
  • The contribution to a 401(k) Profit Sharing Plan:
    Profit Sharing: 25% of $125,000 = $31,250
    Salary Deferral 401(k): $18,500 (through payroll deduction)
    Total contribution = $49,750*

*If you are over 50, you can contribute an additional $6,000 for a total of $55,750

Conclusion…

If you value the loan feature, creditor protection and/or want to maximize your retirement contributions, you should consider a 401(k) PS. If not, the simplicity of a SEP IRA makes it the better choice.

Sheree Tallerman, CEO

PlanPerfect