DIY Retirement Savings: SEP IRAs vs. Individual 401(k)s
Are you a free spirit not beholden to a boss who would like to sock away money for retirement in a tax-deferred savings plan that has higher limits than Traditional and Roth IRAs? This blog post is for you. Two fantastic options are the Simplified Employee Pension (SEP) IRA and the Individual 401(k) (aka the Self-Employed 401(k) or the Solo 401(k)). Both of these plans are easy to set up and administer, have high contribution limits, and offer funding flexibility.
The rundown on SEP IRAs:
Easy to open: SEPs are offered at most financial institutions that offer retirement accounts.
Funding: only by employers, not allowed by employees.
Funding flexibility: No minimum annual contribution amount. In flush years you can contribute more, in tough times you can scale back.
Contribution limits: You can contribute as much as 25% of your compensation (generally 20% if you’re self-employed[1]), up to $56,000 for 2019.
Eligibility: Almost any type of business can offer a SEP. It is best for self-employed individuals and small business owners. An employee is eligible to participate if they are at least age 21, worked for the company in 3 of the last 5 years, and received at least $600 in compensation during the year.
If you set up a SEP for yourself, you have to set one up for each eligible employee.
If you contribute to your own SEP, you have to contribute the same percentage to each eligible employee’s SEP.
Tax benefits: Tax-deferred contributions and investment growth, tax-deductible contributions.
Loans: Not allowed.
Vesting: Immediate.
Administrative considerations: No additional IRS reporting.
The rundown on Individual 401(k)s:
Easy to open: Individual 401(k)s are offered at most financial institutions that offer retirement accounts.
Funding: only by business owners, in dual role of employer and employee.
Funding flexibility: No minimum annual contribution amount. In flush years you can contribute more, in tough times you can scale back.
Contribution limits: You can put away more money than with a SEP. This is because you can contribute both as an employee and an employer. As an employee, you can contribute $19,000 ($25,000 if you’re age 50 or older). As an employer, you can contribute an additional 25% of compensation (generally 20% if you’re self-employed), up to a maximum of $56,000 ($62,000 if you’re age 50 or older) for 2019.
Eligibility: Business owners who have no employees. This includes sole proprietors, LLCs, S and C corporations, partnerships, and tax-exempt organizations. You must have at least a 5% share in the business. Spouses can contribute if they earn income from the business.
Tax benefits: Tax-deferred contributions and investment growth, tax-deductible contributions.
Loans: Allowed, but depends on the plan administrator. Generally you can borrow 50% of the account balance, up to $50,000, and take up to 5 years to pay it back.
Vesting: Immediate.
Administrative considerations: Once your balance reaches $250,000, you have to submit IRS Form 5500 every year.
Both plans allow you to accumulate a formidable nest egg without being subject to the tax consequences of regular brokerage accounts or the low contribution limits of Traditional and Roth IRAs. Start early with smaller amounts and let the magic of compounding interest go to work for you. Or, start later and contribute the maximum possible – with such high contribution limits these plans are perfect for catching up.
[1] Business net profit from your IRS Schedule C, after subtracting out the self-employment tax deduction.