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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 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 401k PS? That depends on how much you want to shelter on a tax-deductible basis for retirement each year.
Simply put: the 401k 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.
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:
A 401k PS plan offers four primary advantages over the SEP:
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.
Owner pays themselves $162,000 salary
The contribution to a SEP:
25% of $162,000 = $40,500 (paid by corporation)
Total contribution: $40,500
The contribution to a 401k PS:
Profit Sharing: 25% of $162,000 = $40,500 (paid by the corporation)
Salary Deferral 401k: $20,500 (through payroll deduction)
Total contribution = $61,000*
*If you are over 50, you can contribute an additional $6,500 for a total of $67,500.
If you value the loan feature, creditor protection and/or want to maximize your retirement contributions, you should consider a 401k PS. If not, the simplicity of a SEP IRA makes it the better choice
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