By: Jason Whitby
By: Jason Whitby, CFP®, CFA, MBA, AIFA®
The advantage of the Individual 401(K) is that the maximum pretax contributions are higher at every level of net earnings before qualified plan deductions for the Individual 401(K) than the SEP IRA. Figure 1 shows the maximum contributions at varying income levels and illustrates that the difference between the two can be considerable.
For example, at $50,000 of net earnings, an individual can contribute up to $31,293 to the Individual 401(K) while the SEP IRA is maxed out at only $9,293. That is a $22,000 difference in favor of the Individual 401(K). Figure 2 shows that Individual 401(K) maximum contributions far exceed those for the SEP IRA until net earnings surpass $175,000. At that point, the difference decreases but is still in favor of the Individual 401(K) by $5,500 at the maximum allowable amounts. This is because the Individual 401(K) has the catch-up provision for individuals over 50 while the SEP IRA does not.
The Independent 401(k) beats the SEP IRA for the maximum plan contribution no matter what the net earnings. For sole proprietors living in high income tax states and for those with additional outside sources of income, this difference could be the difference between a refund and a bill at tax time. You also should remember that this difference is going to happen each year so it can mean the difference between hundreds of thousands of dollars in yourretirement plan over the course of your career.
Advantage No.2: Contributions Are Discretionary and Loans Are Allowed
Independent 401(k) contributions are not mandatory every year. This allows sole proprietors to manage their cash flows and contribute the maximum amount in good years while contributing less or nothing at all should the business take a turn for the worse. In addition, owners can take loans of up to $50,000 or 50% of the value of the benefits in the plan, whichever is lower.
Both the Individual 401(K) and SEP IRA are easy to open and manage. If opened at a discount broker, it is possible to have practically no cost other than trading. Both are extremely flexible when it comes to investing. In addition, as of 2010, neither the individual 401(k) nor the SEP IRA requires that you file Form 5500 with the Internal Revenue Service provided your plan contains less than $250,000 worth of assets.
Another notable advantage of the Individual 401(K) is that unlike the SEP IRA, it is not considered when evaluating the pro-rata cost for a Roth conversion. Let’s look at an example.
If you are in a low tax bracket today and would prefer to pay the taxes but are still interested in maximizing your retirement savings, you can elect to have the employee salary deferral portion contributed after-tax into a Roth Individual 401(K) while the employer contribution is contributed before-tax as a traditional Individual 401(K). The SEP IRA has no such option.
In many cases, the Individual 401(K) is a better alternative to the SEP IRA for sole proprietors. If you are making contributions to an SEP IRA, you should know that the deadline to open an Individual 401(K) is December 31, as opposed to tax filing for the SEP IRA. If you are a sole proprietor, consider opening up an Individual 401(K) today.