Individual 401(k) vs SEP IRA: Which Is Better for a Small Business Owner?

As a small business owner, it can be hard to save for retirement when there are so many other aspects of your business to worry about. Between managing the day-to-day operations and taking care of your business, retirement planning may fall to the bottom of the to-do list.

Even when you do commit to starting a retirement plan, it can be difficult to sort through all the information out there and truly know what’s best for you and your business. Here, we explain two of the most popular retirement savings options for business owners to help you decide which one is right for you.

Individual 401(k)

Also known as a solo 401(k), an individual 401(k) is designed for just you as the business owner. The IRS calls it a one-participant 401(k) and only businesses without employees are eligible.

Key Benefits

Roth accounts: As with other 401(k) plans, the individual 401(k) offers both traditional and Roth accounts. With a traditional account, contributions are made pre-tax and taxes are paid upon withdrawal. Roth 401(k)s, on the other hand, are funded with after-tax dollars, and they grow tax-free. This gives you the flexibility to actively choose the contribution style that works best for your specific tax situation.
Employee deferrals: Individual 401(k) plans also allow employee deferrals in addition to the employer contribution. This option is not available with SEP IRAs.
Loan provisions: Another benefit of this plan is the ability to take loans against the account balance up to the lesser of 50% of the balance or $50,000.
Higher contribution limits: Individual 401(k) plans have two types of contribution limits. First is the profit-sharing limit for employer contributions, which is the lesser of 25% of business revenue or $66,000 (up from $61,000 for 2022). The next limit is the annual employee elective deferral limit, which is $22,500 for individuals under age 50, and $30,000 for those age 50 and older (up from $20,500 and $27,000, respectively, for 2022). The combined limit for both employer and employee contributions is $66,000 (or $73,500 if older than 50), but because there are two types of contributions permitted, most self-employed individuals will be able to contribute more and receive a larger tax break than if they used a SEP IRA.

Drawbacks

Strict reporting requirements: If your account balance exceeds $250,000, you will be required to file an annual return with the IRS. The return consists of Form 5500 and it can be quite extensive. Even if you don’t have $250,000 in your account, you may be required to file.
Only available for businesses with no employees: Individual 401(k)s are only available for businesses with no employees except the owner’s spouse. If you have plans to expand your business and hire additional employees, opening an individual 401(k) is probably not for you. You may be required to convert your plan to a qualified 401(k) and contribute on behalf of your employees if you were to hire any.

SEP IRA

A Simplified Employee Pension (SEP) IRA functions similarly to a traditional IRA, except as the owner, you set up and contribute to accounts for both yourself and your employees.

Key Benefits

Tax-deductible contributions: Your contributions are tax-deductible up to 25% of all participants’ compensation, or up to 25% of net earnings if you’re self-employed.
Higher contribution limit: In 2023, the contribution limit for a SEP IRA is the lesser of 25% of an employee’s compensation or $66,000 (up from $61,000 in 2022). This limit is higher than the limit for tax-advantaged accounts like traditional and Roth IRAs, but as mentioned above, it may not be as high as the limits for individual 401(k) plans.
Easy setup & maintenance: SEP IRAs do not require the extensive reporting requirements required by other qualified retirement plans. You are also not responsible for the underlying investments in your employees’ accounts. As the employer, you simply choose the financial institution you want to work with and you open the accounts. Beyond that, it is the employees’ responsibility to choose and manage their own investments. Additionally, many financial institutions offer SEP plans with little to no management fees, making this a very inexpensive and attractive option for small business owners.
Contributions are discretionary: Contributions to these plans are flexible and discretionary, meaning you can adjust your contributions as your cash flow changes. This ensures you’re never contributing more than you’re bringing in.

Drawbacks

Strict eligibility requirements: According to the IRS, all employees must be allowed to participate in the SEP plan if they are age 21 or older, earned at least $750 in 2023 (or $650 in 2022), and worked for you for at least 3 of the last 5 years. This can make SEP IRAs an inflexible option for small businesses that want to limit the number of employees in the plan.
When you do contribute, you must contribute to everyone: In the years that you contribute to a SEP IRA, you are required to make equal contributions as a percentage of compensation to all eligible employees. For instance, if you contribute 20% of your income to your own SEP IRA, you must then contribute 20% of every employee’s income to their respective accounts. Because of this, SEP IRAs are generally recommended for self-employed individuals or small businesses with very few employees.
No loan provisions, Roth accounts, catch-up contributions, or employee deferrals: Many of the benefits offered by individual 401(k)s are not available for SEP IRAs.

Which Plan Is Right for You?

If you’re a small business owner, don’t wait to start saving for retirement. At Sentinel Financial Planning, LLC, we can help you decide which retirement plan is right for you and your business. To set up an appointment, call us at (443) 906-1565 or email mark@sentinelfp.com.

About Mark

Mark Humphries is the owner and financial advisor at Sentinel Financial Planning, a boutique, veteran-owned and operated investment management, and financial planning firm. Mark focuses on helping business owners, military members, and federal government employees manage their investments and plan for retirement. As a former military service member and federal employee with over 10 years in the financial industry, he is familiar with the Federal Employee Retirement System (FERS) and the Thrift Savings Plan (TSP) and is uniquely qualified to serve his clientele.

Before working in the financial industry, Mark was enlisted in the U.S. Marine Corps from 1999 to 2003, during which he became familiar with the challenges military service members and their families face, especially during deployments. After seven years of working in the financial industry, Mark launched Sentinel Financial Planning to provide a better way for small business owners and federal employees to find reliable financial planning solutions. In addition to the CERTIFIED FINANCIAL PLANNER™ designation, Mark holds a bachelor’s degree in business administration from the University of Central Florida and a master’s degree in personal financial planning from Kansas State University.

Outside the office, Mark enjoys boating, fishing, hunting, and collegiate sports. Additionally, he is a member of the National Association of Professional Financial Advisors, XY Planning Network, Anne Arundel County Pension Oversight Commission, Naval Academy Primary School Board of Trustees, and Warrior Events Board of Directors. To learn more about Mark, connect with him on LinkedIn.