One of the most common questions we hear from new and/or growing small business owners is what type of retirement savings plan they should have for themselves and their employees. There are a few different options, including a 401(k) Plan, Simple IRA, SEP IRA and Solo/Self-Employed 401(k). Today we’ll be focusing on the Solo 401(k) and SEP IRA which makes the most sense for small business owners who only employ themselves and a spouse and want to maximize their contribution amount. Understanding the nuances and advantages of each can empower you to make informed decisions tailored to your specific business needs.
Understanding SEP IRA and 401(k) Plans
SEP IRA (Simplified Employee Pension Individual Retirement Arrangement)
A SEP IRA is a retirement plan established by employers, allowing contributions to be made towards their retirement and, if applicable, their employees’ retirement. Contributions are made solely by the employer, and the contribution limits are generous. The contributions you make to each employee's SEP-IRA each year cannot exceed the lesser of:
- 25% of compensation, or
- $66,000 for 2023 ($61,000 for 2022; $58,000 for 2021; $57,000 for 2020 and subject to annual cost-of-living adjustments for later years).
Solo/Self-Employed 401(k) Plan
The contribution amount for a Solo 401(k) is similar to a SEP IRA, where employers can contribute up to 25% of compensation* not to exceed $66,000 for the 2023 tax year and $69,000 for the 2024 tax year. As an employee of the organization, the business owner can also defer 100% of their compensation up to $22,500 for the 2023 tax year ($30,000 for employees age 50 or older) and $23,000 for the 2024 tax year ($30,500 for employees age 50 or older).
Thanks to the Secure Act 2.0 passed in December 2022, SEP IRA and Solo 401(k)s both have an ability to accept Roth contributions.
Choosing Between SEP IRA and 401(k)
Considerations for SEP IRA:
- Simple Administration: SEP IRAs are straightforward to establish and maintain, with minimal administrative requirements.
- Employer Contributions Only: The employer has the discretion to contribute, and contributions can fluctuate annually, making it suitable for businesses with varying profits.
- Ideal for Self-Employed or Few Employees: Particularly advantageous for self-employed individuals or businesses with few employees due to the flexibility in contribution percentages. Most SEPs, including the IRS model Form 5305-SEP, require you to make allocations proportional to your employees' salary/wages. This means that everyone's contribution is the same percentage of salary and can become cumbersome if you have many employees to contribute for.
Considerations for 401(k) Plans:
- Employee Contributions: Allows for both employer and employee contributions. Depending on your business structure and your calculation of earned income, being able to defer 100% of your W2 earnings may allow for a larger total contribution than what the SEP IRA would allow.
When to Choose a SEP IRA Over a 401(k) and Vice Versa
Opt for a SEP IRA if:
- You have a small business or are self-employed and want a simple, flexible retirement savings option.
- You seek a retirement plan where contributions are entirely at the discretion of the employer.
- You want higher contribution limits than traditional IRAs without the administrative complexities of a 401(k).
- You have a sole-proprietorship structure where you have positive net earnings that allow for you to contribute.
Opt for a 401(k) if:
- Your business structure and how your CPA has advised you to take earnings causes a loss or low net earnings where a calculation of 25% of company net earnings would not allow you to contribute anything to a SEP IRA. Because a Solo 401(k) allows for you to defer 100% of employee compensation, in some instances this allows for a larger retirement contribution than any other retirement plan.
Choosing between a SEP IRA and a 401(k) requires an understanding of your business's unique circumstances and your goals for retirement savings. Before considering which retirement plan you want to choose, first consider the liquidity and whether you have the cash flow to warrant the need for these type of plans. As financial advisors and retirement planning specialists, we seek to provide our small business owner clients with business-specific guidance in selecting the most suitable plan for them and their employees.
Investing in the right retirement savings plan can serve as a cornerstone for securing a financially stable future, not just for your business but for everyone involved.
*Self-employed individuals must calculate their maximum contribution using the rate table or worksheets in Chapter 5 of IRS Publication 560, Retirement Plans for Small Business, or see a tax advisor.