SEP IRA vs. self-employed 401(k)

SEP ira

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.

Related >> Learn how to open a SEP IRA in 30 minutes or less.

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?

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Matt Becker
Matt Becker
7 years ago

Just because some plans have hidden fees doesn’t mean all do. We’re opening a solo 401(k) for my wife with vanguard signs and the only fees are the fund expense ratios. Make sure to compare real numbers from a few different companies rather than relying on generalizations. You may be able to find a low-cost, low-maintenance 401(k) so you can have the contribution flexibility.

Debi
Debi
7 years ago
Reply to  Matt Becker

Why would Vanguard offer and administer an account at no cost to you? What’s in it for them? They’re a business, not a charity, they must be getting paid by someone. Sounds too good to be true.

Matt Becker
Matt Becker
7 years ago
Reply to  Debi

The mutual funds charge an expense ratio. When you open an account and use their funds, they are charging you, just not anything extra beyond the costs that already exist for the mutual funds. It’s the same idea as opening any account with them. Opening the account is free (with certain minimum deposit requirements) and they make their money from the funds you invest in.

retireby40
retireby40
7 years ago
Reply to  Debi

From what I understand, Vanguard is a client ownership company. If you invest in Vanguard, you own a part of the company.
I’ll open a solo 401k at Vanguard later this year. This year I plan to contribute as much as I could. That’s around 50% of my income and solo 401k is the best choice for me. I think regular mean at least once a year, I’ll have to research more.

Wesley
Wesley
7 years ago
Reply to  retireby40

I have a solo 401k for my business using Vanguard. They do not charge me any fee’s except the expense ratios in the fund itself or any fee’s for setting it up. Vanguard beats them all. This one is an easy choice.

wesley

Scott
Scott
7 years ago
Reply to  Matt Becker

Correct Matt.

Both a Self-employed 401(k) and a SEP-IRA are just individual accounts at a brokerage. The only “hidden” fees are the fund expenses.

A 401(k) for a company that requires a TPA and an investment manager all have fees for the functions they perform as well. These are the supposed “hidden” fees.

Thomas | Your Daily Finance
Thomas | Your Daily Finance
7 years ago

I just went on my own freelancing and with my offline company and this is something I have yet to figure out. I think I have a little time until I get back to the point where I am stacking away for retirement again but I thought the 401k was the way to go. Now I am not really sure which I would go with.

John S @ Frugal Rules
John S @ Frugal Rules
7 years ago

I think both can be really good options. One thing I have found is that not all brokerages will offer the solo 401k, but many do offer the SEP. I am not certain as to why that’s the case, but have found it to be so. Like Matt said, I think you can get around the fees by going into some low cost index funds.

Nancy
Nancy
7 years ago

I had an IRA for several years, and then opened an individual 401K five years ago and have been more than happy for the change. The flexibility is key in a business like mine where I have good years and bad years — in the good years, I am able to sock so much more money away, and in the bad years, I have the flexibility to put away very little. If you set up with Schwab or Vanguard there are no excess fees.

Derek Chamberlain @ MoneyAhoy.com
Derek Chamberlain @ MoneyAhoy.com
7 years ago

Maybe I’m just new to this, but this article was very confusing to me. Is someone able to break down the pros/cons in a simpler way?

Something similar to a table would be extremely helpful.

I am clueless as to where the $51,000 max cap comes from. It thought it was $17,500 for 401Ks in 2013??

Kristin Wong
Kristin Wong
7 years ago

Derek, I understand. This stuff was (and is) confusing to me, too. So apologies if I didn’t make it simpler! If you’re looking for a table, the chart I linked to in the article may be of help.

The solo 401k contributions come in two forms: 1. $17,500 comes in “salary deferrals” from the employee (you). 2. The “employer” (you) can contribute to your 401k, too, up to the total amount of contributions being $51,000. I had a long chat with Fidelity on the phone, and this is how it was explained to me.

Hope this makes sense!

Tracy (the Other One)
Tracy (the Other One)
7 years ago

I’m also unclear as to how the IRS calculates this cap, but from what I understand it is essentially the 17K max for the employee (that’s you); plus the maximum match from the employer (in this case, also you). Although most company 401ks match on the order of 3-7 percent of employee contributions, I think they can hypothetically match up to approx. 20-25% (don’t we all WISH!?!)

So that’s why the cap is so high on the solo 401K. The details are fuzzy to me, though.

Tracy (the Other One)
Tracy (the Other One)
7 years ago

Simultaneous redundant post. Sorry!

Michelle at Making Sense of Cents
Michelle at Making Sense of Cents
7 years ago

This is the EXACT type of post that I needed right now. Just yesterday I talked about how I’m trying to prepare for self employment ( http://www.makingsenseofcents.com/2013/06/prepare-for-self-employment.html ) and am looking for any and all tips, especially about retirement saving.

Kristin Wong
Kristin Wong
7 years ago

Good to know! I always worry my freelance/self-employment posts will be unrelatable to most readers, but you gotta write what you know.

So it’s good to read that this is timely for some of you!

Michigan Denise
Michigan Denise
6 years ago
Reply to  Kristin Wong

No, this was a wonderful post! In fact, after reading it, I’m researching even more. I actually am self-employed, and just took a part-time job to save for retirement, while also paying debt. Anymore tips? Actually you posted this in 2013? Wondering how things are going for those stating they had just started with the Solo 401K w/Vanguard. Thanks again for the post. Do you have a blog, how can one follow you?

My Financial Independence Journey
My Financial Independence Journey
7 years ago

Once you take the match away IRAs become far better than 401ks. For self-employed people, I agree that unless you want to tax shelter money over and above the standard contribution of the 401k, you’re better off with the SEP IRA.

I also wonder if self employed individuals can use both an IRA and a 401K like those of us with corporate jobs can.

nicoleandmaggie
nicoleandmaggie
7 years ago

Thanks for this post! Ditto to what Michelle at Making Sense of Cents said. (Though we have a ways to go before we need additional retirement savings room as a couple.)

Tracy (the Other One)
Tracy (the Other One)
7 years ago

Extremely timely post for me. Thanks so much!

krantcents
krantcents
7 years ago

I think when you can save money for retirement at a pretax basis, it is a winner. Depending on my income, I would use the SEP.

Mike@WeOnlyDoThisOnce
7 years ago

I’ll agree with the above–not too many hidden agendas in the 401(k). Great insight to pros and cons, here.

Financial Samurai
Financial Samurai
7 years ago

Kristin or whoever else reading, I’d love to get a clarification on this: “Both plans allow you to contribute 25 percent of your earnings” for a cap of $51,000 in tax deferred contributions. Is it 25% of your REVENUE (top line), or 25% of your OPERATING PROFIT before taxes? Say my business pulls in $200,000 in revenue, but after COGS and operating expenses my business only generates $100,000. Do I get to contribute $50,000 from revenue, or can I only contribute $25,000 from operating profits? I have a feeling there is a misuse of the word “earnings” which usually refers… Read more »

Kristin Wong
Kristin Wong
7 years ago

Sam, why do you have to ask such great questions!? 🙂 I kid. I should have clarified this in the post, sorry. I’m glad you asked! According to Fidelity, it depends on your situation. If you’re a sole proprietor (Schedule C), like I am, then the contribution is is your “net business profit,” meaning: “Net business profit is the total revenue of the business minus all expenses.” So as far as I know, “earnings” is correct. If you fill out a W2 and give yourself a salary, the contribution comes from your paycheck, so expense isn’t taken into account. But… Read more »

Financial Samurai
Financial Samurai
7 years ago
Reply to  Kristin Wong

Howdy Kristin, Thanks for the further info. Good to know about the classification of one’s situation. So “earnings” really is operating profit before taxes and not revenue, which makes sense. I’m just trying to think from a maximum tax minimization standpoint. So perhaps if you give yourself a $51,000 paycheck in one situation, and you are the owner of your S-Corp that earns $100,000 in operating profits, you can contribute $17,500 from your $51,000 paycheck + $25,000 from your operating profits = $42,500. I *THINK* this makes sense. This will leave you with $33,500 in paycheck income before taxes…….. Ahhhh…..… Read more »

Ryan
Ryan
7 years ago

I just formed my own business in 2011 and the SEP IRA has easily been the biggest perk with its high contribution limits.

One pro I didn’t see here was that it is really easy to roll over a traditional IRA from your corporate days into a SEP, which is a simplification I was happy about. I don’t know if this is possible for the solo 401k.

HKR
HKR
7 years ago

Ok, if you’re not self employed, you can have a 401k and an IRA, right? So if you are self employed, is there still a way can you have both?

Kristin Wong
Kristin Wong
7 years ago
Reply to  HKR

I think you can, but as far as I know, the 51,000 limit is per “employee”, not per plan. So you can’t contribute, say, 50,000 in one plan and 40,000 in another. The cap stays the same. So you would have to split the cap between the two. This is also helpful: http://www.irafinancialgroup.com/wp/can-i-have-a-sep-ira-and-a-solo-401k-plan-at-the-same-time/ **Also, while I’ve done a lot of research on this and talked to experts, my boyfriend’s dad suggested I remind readers that I’m not a professional financial adviser. I’m simply doing research for my own situation and sharing it with readers; this is only to serve as… Read more »

David
David
7 years ago
Reply to  HKR

The $50,000 (now $51,000) limit is called the Section 415 limit It does not apply to regular IRAs (Roth or traditional). If you max out an employer plan, you can *still* add the additional money to the IRA or Roth IRA. It *does* apply to a SEP-IRA, though. For a 401(k) which allows employee contributions, the “catch-up” contributions ($5500 in 2012 for folks over 50 years of age) are not counted towards the 415 limit. In theory, in 2012, a person over 50 maxing out a 401(k) (solo or otherwise), plus maxing out an IRA, plus making the “catch-up” contributions… Read more »

HSA
HSA
7 years ago

This question is probably beyound the scope of the post, but I figured I would throw it out there. My wife runs a side business that was formed as an “LLC taxed as an S-corp,” according to the accountant. I’m not sure how’s that’s different from an LLC, but in any event, the profit/loss is passed through to our personal taxes. That was great last year, when she generated a small loss that offset ordinary income at our marginal rate, but this year I expect to generate a profit of around $50k. When we formed the business, I asked the… Read more »

David
David
7 years ago

You missed one potentially huge issue: Roth contributions. Since the SEP-IRA contributions are entirely employER contributions, they are all pre-tax. However, a Solo 401(k) may have a Roth option which applies to employEE contributions. Up to $17500 in Roth employEE contributions in addition to any pre-tax employER contributions you make. Note that Fidelity and Schwab both offer no-fee Solo 401(k) plans – they cost no more, whatsoever, than SEP-IRAs. But neither of them offer Roth options. E*Trade and Vanguard both offer Solo 401(k) plans *with* Roth options. And if you use a third party administrator (which doesn’t have to be… Read more »

JAM
JAM
7 years ago

HSA, I’m a freelance CPA. My company is set up as an S-Corp. The biggest plus with this set up is I pay less self-employment tax. With an LLC, all of the profit is subject to self-employment tax. With an S-Corp, I’m on “payroll” and only that portion of my income is subject to FICA and MEDICARE. The remaining profit of the business is reported to me on a K-1 and I pay income tax on it (just like an LLC), but I don’t pay self-employment tax. As your wife’s other income is so high, she’d be over the wage… Read more »

HSA
HSA
7 years ago
Reply to  JAM

JAM, Thanks for the information. I should probably just sit down with an accountant. In the meantime, I took a look at our 2012 taxes, and it looks like her business is an S-corp. All losses last year passed directly to our personal taxes through a Schedule K-1. So, it looks like my original post was wrong – we’re an S-corp taxed like an LLC. So far, we haven’t paid her anything – it’s just sitting in the business. I assumed that I would pay ordinary personal income tax on whatever is left over at the end of the year…profits… Read more »

JAM
JAM
7 years ago
Reply to  HSA

HSA, If it’s an S-Corp (and your wife actually works for it – i.e. she’s not just a passive owner), she should be on payroll for the value of the work she provides. The IRS will jump all over a “$0 payroll and all K-1 income” situation as it avoids all self-employment taxes. I’d rather determine the amount to pay myself via a W-2 than have the IRS determine for me via an audit! They’d probably say all of it should be W-2. In your exact situation it’s not as large a tax savings as your wife is already over… Read more »

Baggy M
Baggy M
6 years ago
Reply to  JAM

Hi Jam,

I have an LLC with husband and wife only..Never ran a payroll and it’s treated like equal percentage partnership. Only one of us generated income through contracting and so we shall have K1 income for profit sharing. Can we also take employee contributions too ? We want to maximize on our solo 401K with both types but not sure if each of us need to generate income and even if we did that, without w2 we can still benefit from it. Lots of websites say that LLC partnership can do it but any thoughts ?

Carly
Carly
7 years ago

Save, save, save. Whether it is a SEP of 401k or another plan the key is to start early and be consistent. Save with every paycheck and take advantage of any employer matching plan.

David Garrett
David Garrett
7 years ago

Bank on Yourself is a much better plan. No way I would invest in anything the Government might be able to take soon.

David
David
7 years ago

One more thing re: Solo 401(k) and S-Corps This is more about a difference between an S-corp and a sole proprietorship, though. Since the owner of an S-corp needs to issue himself a W-2 and declare his wages as differentiated from the business income, this can has an impact on how and how much may be put away into a solo 401(k) — employee contributions (“payroll deductions”) must be made within 15 days after the end of the close of the fiscal year (usually Dec 31). The profit-sharing contributions (the 25% of earnings) don’t have to be deposited until taxes… Read more »

ken lavoie
ken lavoie
7 years ago

I second the SIMPLE IRA. 12,000 per year salary deferral plus 3% company match, and they are extremely “simple” to manage, especially at Vanguard. No fees at all and great investment options. If you have enough to warrant a solo 401k then that changes things, but I love the SIMPLES for their simplicity and versatility and economics.

Mark
Mark
6 years ago

Kristin,

Late to this topic, but curious. What if we’re in the gray area of freelancers? Not an S-Corp, not an LLC, but a for-hire worker in the film industry? I’m hired by producers, get paid through a payroll company during production (including pre- and post-), and then wait it out on unemployment until the next gig. The Roth or traditional IRA get maxed out quick. Am I eligible for either the solo 401k or the SEP, or have I fallen through the cracks?

David Roodman
David Roodman
6 years ago

Thank you for this post. Very helpful. Here’s what I’m wondering about: how the self-employment tax interacts with these options. I would think that contributing out of your own pay, like under the 17500 401k limit, does not reduce self-employment tax, whereas contributing out of profits, as in the SEP IRA, *does* get deducted from self-employment tax. If so, this is a big deal.

David
David
6 years ago
Reply to  David Roodman

David, no – the SEP does *not* help with the self-employment taxes, not for the employer. If you have employees, contributions you make on *their* behalf are deductible from your business income. But contributions you make on your own behalf are deducted in the “adjustments” section on page one of your tax return, not on your Sched. C. If you want to save on self-employment taxes, it may be possible via other structures such as an S-corp, but that has other complexities and consequences, and is not necessarily the right answer, either. (and it would mean you need to file… Read more »

Jenny
Jenny
6 years ago

I didn’t see it stated here, but 401k can be taken out starting 55, but ira has to wait till 59 1/2 years old. So 401k is better for people who want to retire early.

Longboat Retirement
Longboat Retirement
5 years ago

Generally speaking, if you have or can have some self employment, a Solo 401k is better. The notion that a Solo 401k has more administrative costs is simply not true. A truly self directed Solo 401k has almost no administrative costs, because you are administrating. Buying a so called self directed account with a brokerage house or big banking institution, is hardly self directed. These accounts just give you a larger menu of options; these accounts are still controlled by the custodian, who you can “direct”, if he/she finds your choices benefit them through a nice commission. If your investment… Read more »

Debbie
Debbie
5 years ago

I have read all of the posts but none of them refer to my situation. I have a C-Corp. I write checks to myself and I pay quarterly estimated taxes. The checks I write to myself are reported on line 21 of the 1040 as NON-EMPLOYEE COMPENSATION (no W-2, 1099 or K-1.) I file schedule SE for this compensation. My question is, am I allowed to open a SEP or Solo 401K under the C-Corp? Thank you!

YG
YG
4 years ago

Debbie,

I think C Corp employees cannot use Solo 401K.

I don’t know the direct answer to your question but S-Corp might be better for you since you seem to be the owner as well as employee. Unless you have more than 100 employees OR have partners that have uneven profit sharing ratios.

Either way as an employee of the C or S corp you

Chris
Chris
4 years ago

I’m self-employed and I opened up a SEP IRA and contributed $5000 this year 2016 (less than 20% of my income) After researching a bit I decided to open up an Indivdiual 401K account and contributed $8000 this year (2016) Realizing i don’t need to have both accounts i closed the SEP IRA and rolled that over to the individual 401K. My question is am i allowed to make contributions to the SEP and Ind. 401K. in the same year so long as i’m not over the contributions limits? Both of the accounts are with TD Ameritrade they weren’t very… Read more »

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