SEP IRA vs. self-employed 401(k)
A couple of months have passed since my 30th birthday, and that means getting started on some of my money resolutions for the year. One of those resolutions was choosing an additional savings plan for retirement.
Currently, I have an IRA that I'm planning on — and getting close to — maxing out for the year. Last time I wrote about my financial goals, I planned to save more for retirement by opening a self-employed 401(k).
Since then, I've picked up “The Money Book for Freelancers” (thanks, El Nerdo!). Authors Joseph D'Agense and Denise Kiernan introduced this novice freelancer to the SEP IRA.
Actually, the authors have an entire section on retirement options for the self-employed. However, the SEP IRA stood out to me as a worthy contender for my situation. Since reading, I've been comparing the two accounts, SEP IRA and one-participant 401(k) plans — also called Solo 401(k) — noting their advantages and disadvantages. I've been working toward making a decision, and I thought I'd share some of the basics of what I've learned.
401(k): Potentially Higher Contribution Limits
After Fidelity sent me some info on self-employed 401(k) plans, I inquired about the SEP IRA. I found out that, while both plans have a cap of $53,000 (for 2016), the 401(k) allows you to contribute more of your salary below that cap. For 2017, the cap will be $54,000 for the SEP IRA.
Both plans allow you to contribute 25 percent of your earnings (for sole proprietors, the contribution is 20 percent). But the 401(k) allows an additional $18,000 in salary deferrals from 2015 to 2017. So, depending on your salary and how much you want to contribute, the 401(k) might be a better option, because you can save more money in it.
Jonathan Ping, who has contributed to Get Rich Slowly in the past, once wrote about the differences in contribution limits between these two types of accounts. He wrote that article in 2006, and while limits have changed, the fundamental idea is the same:
“…you can make very little self-employed income and basically defer it all, which you can't do with the SEP IRA. This gives you that added flexibility which is especially beneficial for those who have some self-employed income as secondary income and want to get the most tax advantages. For example, if you made $15,000 of eligible compensation, you could sock all $15,000 of it away with a Self-Employed 401(k), but only $3,750 with a SEP IRA.”
To me, this is the most noteworthy difference between the two plans: the potentially higher contribution limits. Both accounts are tax-deductible and tax-deferred. So, I can see how the additional deposit allowance would be a big draw for the 401(k).
However, I personally don't plan on being able to contribute more than 25 percent of my salary for retirement anytime soon. As a result, the potential may be lost on me. Perhaps this will change in the future, but for now, I don't think I'll reach the 25 percent limit.
SEP IRA: Less Maintenance
“These accounts are popular with freelancers for a reason,” D'Agnese and Kiernan write. “They're so easy to open that you can do it online in a few minutes.”
Indeed, there's much less paperwork involved with the SEP than there is with the 401(k). Of course, a little paperwork shouldn't keep you from making the most out of your money, but if I've already decided on the SEP, this is icing.
401(k): Substantial, Recurring Payments
Also, Fidelity explained to me that with the 401(k), you have to make “substantial, recurring” payments — IRS's words, not theirs. I'm not entirely clear on this, but because this is a qualified plan, the account must meet requirements of the IRS code. Two of those requirements are that the payments must be substantial and recurring.
Thus, if you're not contributing regularly to this account, there's a chance that the IRS can tax and penalize you.
With the SEP, it's up to you when and how much you want to contribute. Another administrative responsibility of the Solo 401(k)? If your plan assets exceed $250,000, you're required to file IRS Form 5500-SF annually.
Bottom line: there seems to be considerably less maintenance and administrative work with the SEP IRA.
401(k): Hidden Fees?
D'Agnese and Kiernan call the SEP “dirt cheap,” and the Wall Street Journal has reported:
“Solo 401(k)s do in some cases have higher administration fees than SEP IRAs or other plans. Investors need to weigh whether they save aggressively enough to justify those fees.”
Combine this with all of the recent attention on hidden 401(k) fees, and the SEP is an even more attractive option.
There are some additional details that don't apply to me, but I think they're still worth noting. The 401(k) has a loan option, for instance. And with the SEP, “the minute you hire an employee, you must contribute the same amount of money to that employee's SEP as you're paying into your own,” write D'Agnese and Kiernan. They add that, with the Solo 401(k), once you hire employees, the plan is no longer solo and “you must expand your plan to offer your employees the same benefits you're enjoying.”
For my simple needs in the time being, the SEP seems like the best route for my retirement saving. For anyone interested, Fidelity also has a handy comparison chart detailing these two types of retirement accounts and some additional accounts.
These are just the basics — are there additional drawbacks or benefits you've discovered from using either type of account?