When it comes to saving for retirement, there are a lot of options to choose from. Two of the most popular are the SEP IRA and the 401(k). But which one is better for business owners? In this blog post, we will break down the pros and cons of each plan to help you make an informed decision about which is right for you.
A Simplified Employee Pension Plan, or SEP IRA, is a type of retirement plan that may be attractive for self-employed individuals and business owners with few employees. You can contribute up to 25% of the employee’s total compensation or a maximum of $61,000 for the 2022 tax year, whichever is less.
If you’re self-employed, your contributions are generally limited to 20% of your net income. (Net compensation for self-employed individuals is generally the net profit from IRS Schedule C reduced by the deductible self-employment tax. The eligible compensation limit, indexed for inflation by IRS is $305,000 for 2022).
SEP IRAs are very easy to set up, and you can open one through most major custodians with generally no opening cost or fees for ongoing administration. These retirement plans do not require a third-party administrator and do not require plan tax filing with the IRS (more on this below when we get to 401(k) plans).
From an investment standpoint, you have full control over the plan assets and can pick and choose how this account is invested across available ETFs, mutual funds, stocks, bonds, etc.
Contributions to a SEP IRA are tax-deductible for federal income taxes. For example, if you contribute the full $61k for 2022 and you are in the top marginal tax bracket (37%), the SEP contribution saves you $22,570 in federal taxes when you file. If you go this route, the contribution is tax-deductible, the funds can be invested and grow tax-deferred, then when you go to distribute the funds during retirement, each distribution will be taxed as ordinary income in the year of the distribution. SEP IRAs are also subject to Required Minimum Distributions (RMDs) at age 72, which means you must take a portion of the account out based on your individual life expectancy on an annual basis.
If you prefer tax-free savings, you can instead forgo this tax deduction and convert the full SEP IRA contribution to a Roth IRA. Generally a Roth conversion is considered a taxable event, and the full balance of the conversion is included in gross income when calculating your federal income tax for the year. However, if you contribute to a SEP IRA and convert the full balance in the same year, there is no tax due, and the full balance is transferred to the Roth IRA where it grows and distributes 100% tax-free (assuming you satisfy 5-year rule and age 59 ½ requirement). There is no tax because you are essentially ‘cancelling out’ the deduction that you would have otherwise received if you left the funds in the SEP IRA and did not convert to Roth. This is known as the “MegaBackDoor Roth” strategy, and you can learn more about it here- https://ewa-llc.com/blog/do-you-know-if-your-employer-retirement-plan-allows-for-mega-back-door-roth-contributions/
In this scenario, you do not receive a tax deduction for the contribution, the funds can be invested and grow tax-free, then when you go to distribute during retirement, the distribution is tax-free assuming you meet IRS distribution requirements.
The major downside of a SEP IRA is the contributions must be made proportionally across all W2 employees. For example, if you are a business owner and pay yourself $250,000, you would need to contribute 24.4% of your compensation to fully max out the SEP IRA for 2022 to reach the 61k max. This 24.4% contribution must be made across the board for all W2 employees, so it is important to keep this in mind if this applies to you. If you are a solo business owner with no employees, then this is a great option, but if you have 10 employees, this can become costly very quickly (more than a general match in a 401(k) as mentioned below).
A few notes on plan entry requirements:
Important to note that your plan can be tailored to be less restrictive than above, if preferred.
Lastly, SEP IRAs can also lead to aggregation issues if you are funding a Roth IRA via the “backdoor Roth” strategy. (video resource here- https://vimeo.com/751293931)
A 401(k) plan is a company-sponsored plan which allows for contributions on a pretax, after-tax, or Roth basis (depending on how the plan is structured). This option may be attractive if you are a business owner with multiple employees, or if you are a single business owner with existing pretax IRA assets looking to avoid aggregation and complete backdoor Roth IRA contributions.
401(k) plans can be implemented for your company and can cover multiple employees. You can customize contributions for yourself as a business owner (subject to discrimination testing), you can offer employer matching contributions, and you can give employees the ability to plan for their own retirement (as they can choose how much to contribute and can decide whether to contribute on a Roth vs Pretax basis). An easy way to pass discrimination testing is to implement a safe harbor contribution (generally costing 3% of compensation per employee), which could end up being much less than a SEP contribution to employees as mentioned above.
401(k) plans have 4 components to give tax diversification both now and during retirement:
In 2022, the combination of these (415c limit) cannot exceed $61k (or $67,500 if over age 50). In 2023 these limits are increasing, and the combination of these (415c limit) cannot exceed $66k (or $73,500 if over age 50).
401(k) plans can also be used to avoid aggregation issues. For example, if you have a pretax IRA balance, you can consolidate this by completing a direct rollover to move the IRA into the 401(k) plan. This effectively clears aggregation and allows you to continue funding a Roth IRA via the backdoor Roth strategy (video resource here- https://vimeo.com/751293931).
401(k) plans require a Third-Party Administrator (TPA), who completes nondiscrimination testing and is responsible for preparing annual tax filing documents for the plan. A TPA is an added expense, generally somewhere around $2,000/year, and is required in order to keep the plan in good standing in regard to IRS compliance.
Nondiscrimination tests can limit the amount that highly compensated employees (HCEs) can contribute to the 401(k) plan. HCEs include the following:
The nondiscrimination tests include:
In general, a 401(k) requires more upkeep each year, TPA costs, and decision making according to cash flow in business when compared against a SEP IRA. If an employer wants to contribute the max for themselves, it will cost some amount of money to pass the test by providing profit sharing contributions above the safe harbor for the employees.
Choosing the right retirement plan is an important decision for anyone, especially business owners who need to balance the interests of themselves, their employees, and their business. It is important to evaluate the pros and cons of all options before committing to a strategy as mistakes can be costly (in terms of actual dollar cost, and in regard to the impact the decision will have on your personal financial planning). Please consult with a financial and tax professional in order to determine which plan is appropriate for you and your business.
Equilibrium Wealth Advisors is a registered investment advisor. The contents of this article are for educational purposes only and do not represent investment advice.
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