Updated for 2023
Did you know that the retirement vehicle you choose can have a major effect on your tax liability? You may have asked yourself, “What’s the difference between a SEP IRA and a 401k?”
When you own your business, it’s on you to figure out your retirement. There isn’t an employer handing you a packet of information, wrapped up in a shiny bow. You get to choose. This is both amazing and also horrible lol. In this post, we will look at the differences between a SEP IRA and a 401k, along with the tax perks and potential drawbacks.
What is a SEP IRA?
A SEP IRA, or Simplified Employee Pension Plan, allows employers to set aside money in retirement accounts for themselves and their employees. It is available to businesses of all sizes and does not have the costs of other conventional retirement plans. It can be opened by sole proprietors, corporations, partnerships, and other types of small business entities. Contributions are made solely by the owner of the company. While an EIN is not a legal requirement of opening a SEP IRA, some financial firms may ask for one.
What is a 401k?
A 401k plan is also set up by employers to help fund retirement and can be contributed to by both the employee and the employer. Many freelancers and small business owners think that if they don’t have a huge corporation or a ton of employees they cannot contribute to a 401k and this is not true. Small businesses with no employees can set-up a Solo 401k. 401k plans are available to everyone as long as you have an EIN. Also please remember that you do not need a corporation or LLC to get an EIN.
What are the Differences Between a SEP IRA and a 401k?
This is where it gets juicy. The total contribution max for each one is the same – $61,000 for calendar year 2022 and $66,000 for calendar year 2023 – the biggest difference between a SEP IRA and a 401k is how much you can contribute against each dollar of taxable income.
Each dollar you are able to contribute is a function of income that is subject to self-employment tax. And that means you want to be able to contribute as much as possible, without needing more income that is subject to self-employment tax (because that means higher taxes).
Please note that the way your contributions are calculated vary depending on whether or not you have a corporation (or an LLC taxed as a corporation).
As you will see in the chart below, compared to a 401k, a SEP IRA requires more income that is subject to self-employment tax, which translates to higher taxes. Choosing a 401k over a SEP also means that you can earn less and contribute more (see below that only $174,000 a year is required for a corporation with a 401k compared to $344,544 required for a non-corporation with a SEP IRA). The differences in these numbers is serious – proper planning makes building wealth attainable and accessible for more people.
- SEP IRA
- No Corp: 25% of your adjusted earned income up to the maximum allowed contribution
- Corporation: 25% of your wages, up to the maximum allowed contribution
- No Corp: $22,500 can be contributed as yourself with an additional contribution available from the business of 25% of your adjusted earned income up to the maximum allowed contribution
- Corporation: $22,500 as yourself with an additional contribution available from the business of 25% of your wages up to the maximum allowed contribution
|SEP – Not a Corp||401k – Not a Corp||SEP – Corp||401k – Corp|
|Total Income Subject to SE Tax Required to Max Out||$344,544||$230,525||$264,000||$174,000|
|Estimated Total SE Tax (does not include additional medicare tax)||$29,092||$26,039||$26,935||$24,525|
The 401k allows you to get to the same $66,000 on less tax. Want to learn more and run numbers for yourself? Fidelity has this fancy calculator that will give your maximum contributions under both plans.
Please keep in mind that this is a simplistic approach that doesn’t take any additional nuances into account such as having other employees on your business’ payroll.
With a SEP IRA, decisions are made solely by the company’s owner. The eligibility requirements apply equally to owners and employees and contributions must be equal. Employees can withdraw money, but they are subject to a 10% penalty if done before the age of 59.5.
With a 401k, the employee is in the driver’s seat. They make the decisions on which funds to contribute to and are able to take out a loan on their money if needed. While there are requirements and penalties to withdraw funds before age 59.5, a 401k can offer more flexibility on contribution amounts.
Opening a SEP IRA or 401k
A SEP is VERY easy to set-up and manage. You can open a SEP IRA at any brokerage company like Vanguard, Fidelity, or Betterment. If you don’t plan on contributing too much and just want something simple to get started, a SEP IRA is probably the way to go – you always have the option of rolling it into a 401k later.
On the other hand, a 401k is a little more difficult to set-up and comes with administration costs. However, a 401k offers so much more power in being able to really maximize tax savings in more ways than one that these costs pay for themselves. We love setting-up 401k plans for our clients – it’s our mission. Please give us a shout if you want us to make your 401k dreams a reality.
It is never too early to begin planning for retirement. When you’re a small business owner, nobody is going to do the work for you. Unfortunately, when someone transitions to self-employment, one of the first things to go is saving for retirement. Don’t forget to put yourself and your future first. Even saving just $50/month can make a huge difference in your retirement.
Our team would love to help advise you on what you should consider and how to maximize your retirement savings. Reach out to us today!
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This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Countless assumes no liability for actions taken in reliance upon the information contained herein.