When planning for retirement, choosing the right savings plan is crucial for maximizing your financial security. Two popular options for individuals and businesses are the SEP IRA and the 401(k) plan. Understanding the differences between these two retirement savings vehicles can help you determine which is best suited to your needs. In this article, we’ll explore the key differences between SEP IRAs and 401(k) plans, including contribution limits, eligibility, and tax benefits.
Overview of SEP IRA and 401(k) Plans
What is a SEP IRA?
A Simplified Employee Pension (SEP) IRA is a retirement plan designed for self-employed individuals and small business owners. It offers a simple and flexible way to save for retirement, with contributions made by the employer on behalf of employees.
Key Features:
Employer-Funded: Only employers can contribute to SEP IRAs, with contributions based on employee compensation.
Easy Administration: SEP IRAs have minimal administrative requirements, making them a popular choice for small businesses.
Flexible Contributions: Employers can decide each year how much to contribute, offering flexibility based on business profitability.
What is a 401(k)?
A 401(k) plan is a retirement savings plan offered by many employers that allows employees to save a portion of their salary on a pre-tax basis. Employers can also make matching or discretionary contributions to employees' accounts.
Key Features:
Employee and Employer Contributions: Employees can contribute to their 401(k) accounts through salary deferrals, while employers may provide matching contributions.
Higher Contribution Limits: 401(k) plans offer higher contribution limits compared to SEP IRAs.
Loan and Roth Options: Some 401(k) plans offer loan provisions and Roth options for after-tax contributions.
Key Differences Between SEP IRAs and 401(k) Plans
1. Contribution Limits
SEP IRA Contribution Limits: Employers can contribute up to 25% of an employee’s compensation or $69,000 (for 2024), whichever is less. This limit applies to each eligible employee. Catch-up contributions are not permitted with SEP IRAs.
401(k) Contribution Limits: Employees can contribute up to $23,000 (for 2024) to their 401(k) account, with an additional catch-up contribution of $7,500 for those aged 50 or older. Total contributions, including employer contributions, cannot exceed $69,000 (or $76,500 with catch-up contributions).
2. Eligibility
SEP IRA Eligibility: Employees must be at least 21 years old, have worked for the employer for at least three of the past five years, and have earned at least $750 (for 2024) in compensation. Employers can set less restrictive eligibility requirements if desired.
401(k) Eligibility: Employers can set eligibility requirements. The IRS guidelines state that an employee must be permitted to participate if they are at least 21 years old and have completed one year of service can participate in the plan. An employer can choose to immediately enroll a new hire when they start their job, or they can require them to work for the company for a certain number of months before they become eligible (say three to six, for example).
Read more about how to determine employee eligibility for a 401(k) plan.
3. Contribution Flexibility
SEP IRA Flexibility: Employers have the flexibility to decide how much to contribute each year up the the IRS limits, depending on business profitability. Contributions are not required every year.
401(k) Flexibility: Employees have the flexibility to choose their contribution amount each year, up to the IRS limits. Employers can make contributions to their employees 401(k) plans, but they need to ensure they meet certain nondiscrimination requirements.
4. Administrative Complexity
SEP IRA Administration: SEP IRAs are easy to set up and maintain, with minimal paperwork and no annual filing requirements for the employer.
401(k) Administration: 401(k) plans involve more administrative responsibilities, including annual reporting and compliance testing to ensure nondiscrimination.
5. Tax Benefits
SEP IRA Tax Benefits: Contributions are tax-deductible for the employer, and funds grow tax-deferred until withdrawal. Withdrawals are taxed as ordinary income.
401(k) Tax Benefits: Employee contributions are made on a pre-tax basis, reducing taxable income. Funds grow tax-deferred, and withdrawals are taxed as ordinary income. Roth 401(k) options allow for after-tax contributions with tax-free withdrawals in retirement.
There are also many tax benefits to employers who are setting up a 401(k) plan for the first time. Learn more.
Choosing the Right Plan for You
1. Consider Business Size and Structure
Sole Proprietors: SEP IRAs are an excellent choice for self-employed individuals seeking simplicity and flexibility.
Businesses with More than Two W-2 Employees: If you want to offer competitive benefits to attract and retain employees, a 401(k) plan is a better option. There are increasingly more affordable options on the market for businesses of all sizes.
2. Evaluate Contribution Goals
High Contribution Limits: If maximizing retirement savings is a priority, a 401(k) plan with higher contribution limits may be advantageous.
Variable Contribution Needs: If you prefer flexibility in annual contributions based on business profitability, a SEP IRA may be more suitable.
3. Assess Administrative Capabilities
Simplified Administration: If ease of administration is a priority, a SEP IRA requires less paperwork and compliance oversight.
Comprehensive Benefits: If offering a comprehensive benefits package is important, a 401(k) plan with additional features such as loans and Roth options may be ideal.
Conclusion
Choosing between a SEP IRA and a 401(k) plan depends on your unique business needs and retirement goals. SEP IRAs offer simplicity and flexibility, making them an attractive option for small businesses and sole proprietors. In contrast, 401(k) plans provide higher contribution limits and additional features, making them suitable for medium and large businesses with more complex retirement needs. Carefully evaluate your financial objectives and consult with a financial advisor to determine the best retirement savings option for you or your business.
