If you’re thinking about starting a retirement plan for your business, you probably have heard of 401k plans, and perhaps you’ve heard of the SEP IRA too. So, what are these plans and how might a business choose one over the other? Let’s dive in and look at both options.
What is a SEP IRA?
SEP stands for Simplified Employee Pension, and this type of retirement plan enables employers to make optional contributions on a tax-deferred basis. When contributions are made, they must be disbersed to all eligible employees, and only the employer can contribute to the plan. Whether you’re self-employed or have employees, a SEP IRA is something you can consider. In determining the company contributions, you can include up to 25% of the employee’s total compensation not to exceed the annual limit (which is $58,000 for the 2021 tax year).
The SEP IRA has less options than a 401k but can be a little easier to administer. If your business income is unpredictable, the SEP IRA contributions are optional each year, so it can be a good fit. Do know that 401k’s allow for optional employer contributions too. You will just need to ensure you setup a plan design that enables optional employer contributions. This is typically done via a 401k profit share. And unlike a SEP IRA, employees can contribute to the 401k regardless of whether the employer provides any contributions each year or not.
Why choose a 401k?
While the SEP IRA can be a good option for some businesses, it does lack some compelling features that are common to the 401k. It’s one reason 401ks tend to be better known and popular. These include the ability to contribute as both an employee and employer, catch up contributions for those 50 years of age or more, Roth 401k option, loan option, and vesting options. This can be beneficial to you and can help attract and retain employees. Plus, personal contributions can help any employee better manage their taxes each year while saving for retirement. Here are the major differences at a glance:
| Feature Comparison | SEP IRA | 401k |
|---|---|---|
| Employee contributions allowed? | No | Yes, up to $19,500 per year in 2021 |
| Catch-up contributions allowed? | No | Yes, an additional $6,500 for those over age 50 in 2021 |
| Employer contributions required? | No | Optional – dependent on the plan design you choose |
| Roth contributions allowed? | No | Yes, plus no income restrictions |
| Loans allowed? | No | Yes |
| Vesting options available? | No | Yes |
| Employer contribution limits? | Up to 25% of net income, not to exceed the overall annual limit ($58,000 in 2021) | Up to 25% of net income, not to exceed the overall annual limit ($58,000 or $64,500 for those over age 50 leveraging catch up contribution) |
The employee contribution option provides additional flexibility for self-employed individuals choosing a solo 401k, since they too have the option to contribute as both the employer and employee of their own business.
Businesses with employees can choose between a Traditional 401k or Safe Harbor 401k plan depending on their business needs, and this offers additional customization whether choosing to match employee contributions and/or select employee vesting schedules. In general, 401ks are going to give you more options than a SEP IRA, and both offer high contribution limits. Happy saving.