A few months ago a comment showed up on my discussion of our consulting business retirement investments. The question was around, can a SEP IRA be used in conjunction with a individual 401K? This lead me to this post, where we will explore the differences between a SEP IRA and individual 401K.
A review of Individual 401Ks
So if you read that previous article you will learn all about the rules of a individual 401K. To review you need to be self employed to have a individual 401k. Contributions have an $18.5K employee contribution portion and a employer profit sharing contribution of 20% for sole proprietorship (25% otherwise). Read more to learn about how to calculate your possible contributions and the value of these accounts here.
What is a SEP IRA
A SEP IRA works in much the same way as an individual 401K of even a employer 401K. Essentially you insert funds tax free and when you withdrawal you pay taxes on that income. The contributions are tax free in the form of deductions. Also like the individual 401K you can contribute up to a yearly maximum of $55K dollars.
$55K is per Employer
An important aside I did not mention previously, but applies to both plans for the high income self employed, the $55K plan limit applies per employer. So your employer’s 401k contributions, if unrelated to your side business, do not impact your overall individual or SEP contributions. It does impact your employee contribution limits to a individual 401K. So say I contribute 18.5K to an employer 401K and receive a 6K match. I can also contribute 55K as an employer to my SEP IRA or Individual 401K, but I cannot make additional employee contributions. Note, unrelated employers have specific definitions which you can review here.
Contribution Differences between an Individual 401k and a SEP IRA
The difference between a individual 401k and a solo 401k are primarily in how you contribute. In the SEP IRA case you only contribute as if you are the employer. So essentially for a sole proprietorship you can contribute 20% of your earned income. Other business structures can contribute 25% of their income. The calculation of this employer contribution is the same as the individual 401K. As discussed in the prior article net income is your revenues minus your expenses. Earned Income is net income minus half your self employment tax or 7.65%. So in a sole proprietorship example where you make $50K net income (revenue – expenses) to determine your contribution limit you would take 50K * (1-.0765) *20%. So in this example you could contribute $9,265.
*A note, one up in the air piece of the 2017 tax law is how the 20% qualified business deduction plays into this calculation. The general assumption would be employer contributions reduce the amount to which the 20% deduction applies since they are a wage expense. Now would be a good time to remind you Full Time Finance is for entertainment purposes only. Any financial and tax decisions are yours and yours alone.
SEP IRA lacks Employee Contributions
However unlike the individual 401K, the SEP does not qualify for contributions by the individual. So the individual 401K in the above scenario could contribute $18,500 + (50K-18.5K)* (1-.0765)*20% individual contribution. The SEP however can only contribute $9,265. So in cases where you do not have an employer where you also individually contribute to a 401k at the 18.5K max, the individual 401K allows you to contribute more to your retirement accounts. (remember as stated before the 18.5K employee contribution includes what you contribute through your employer, the 55K does not).
SEP IRA lacks Catchup Contributions
In addition, even if you have an employee contribution to a 401K, your SEP IRA has an additional downside in that it does not allow catchup contributions. If you are over 50 the individual 401k allows 24.5K a year in employee contributions and $61,000 in total contributions. The SEP IRA remains at $55K regardless of age.
SEP IRA Subject to Pro Rata Rule
A SEP IRA also can run afoul of the IRS pro rata rule. Of course this could impact your ability to do a back door ROTH. The Individual 401K generally does not experience pro rata issues if you are not investing in it both pre and post tax.
Individual 401K may have higher fees and does require more Forms
In most scenarios an individual 401K will be superior to a SEP IRA because of the above differences. However, an individual 401K does have additional fees and reporting rules over a SEP IRA, but in todays era the differences are largely pedantic with big companies like Fidelity and Schwab no longer charging most of the fees. Otherwise a few extra forms on your taxes won’t kill you. The big one of these is the requirement to file a FORM 5500 EZ if the value of your account exceeds $250,000.
A few more minor Individual 401K benefits
On a less important note the Individual 401k allows loans from your balance should you need access to the money in a hurry for an emergency. A SEP IRA does not allow such loans. As discussed previously you should, except in the case of dire emergency, never consider using this capability. In addition a Individual 401K also can provide a ROTH option, allowing you to pay taxes on the balance now and withdrawal tax free. This may be an advantage to some in diversifying their exposure to future tax rate or bracket changes. A SEP IRA also does not provide this option.
Can you Do both a Individual 401K and a SEP IRA?
So back to the original comment question, can you do both? Well in some cases yes you can, but it would generally not be advantageous. You see, if the employer contributions to a individual 401K and SEP IRA come from the same employer they come from the same pool of earned income. As such your employer contributions to one reduces your contributions to the other. In other words 20% of your earned income and 55K are your maximum contributions regardless of the number and type of plans. Also be aware some types of SEP IRA may not be openable in conjunction with a solo 401k. You can read more on this here if truly interested, but this is probably not worth your time.
Do you have a SEP IRA or an Individual 401K? Why did you choose one over the other?