SEP or 401(k) Profit Sharing Plan

What Should I Choose?

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

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

Features of a SEP IRA

The SEP is a great choice for self-employed people or owner/spouse businesses who want to contribute up to 25% of their W-2 earnings or 20% of net income up to the contribution limit. If that is sufficient, then the SEP will be the easier choice.

This type of plan also has the optional flexibility to allow you to convert to a Roth immediately or anytime in the future. So you can time the Roth conversion to minimize taxes. With the Roth 401k you must pay the taxes in the year you contribute. Also, with the SEP:

  1. You must include part-time employees.
  2. All employer contributions are 100% vested immediately.
  3. Assets are not protected from creditors.
  4. No loans are allowed.

Features of a 401k Profit Sharing Plan

A 401k PS plan offers five primary advantages over the SEP IRA:

  1. Potentially greater retirement contributions at the same income level.
  2. The option of a tax-free loan using the balance of the plan as collateral. Loans are permitted up to 50% of the total 401k PS value with a $50,000 maximum.
  3. You can exclude employees who work less than 500 hours.
  4. Set up a six year vesting schedule.
  5. Asset protection from creditors.

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

An Example of The Difference

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

For example, let’s say your client pays themselves $116,000K in salary. Here’s what they can contribute to 401k Profit Sharing Plan:

The contribution to a SEP:

Employer Profit Sharing: 25% of $116,000 = $29,000 (paid by corporation)
Total contribution: $29,000

The contribution to a 401k Profit Sharing Plan:

Profit Sharing: 25% of $116,000 = $29,000
Salary Deferral 401K: $18,000 (through payroll deduction)
Total contribution: $47,000*.

*If you are over 50, you can contribute an additional $6,000 for a total of $53,000


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

Feel free to contact us!

Phone: 949-223-8397

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