In part one of our discussion of the individual 401(k) vs SEP IRA debate, we looked at some of their tax benefits, deductions and general contributions. In this second part, we’ll look more in-depth at Roth contributions, loan provisions and deadlines for funding these accounts. (For more, see: Individual 401(k) vs SEP IRA: Deductions & Contributions.)
Individual 401(k) vs SEP IRA: Roth Contributions
As mentioned above, a big difference between these plans is how they are funded. SEP IRAs are only funded with employer contributions. This is in contrast to the individual 401(k) where there are two funding sources:
- Employer profit sharing (up to 25% of compensation)
- Employee salary deferral (up to $18,000 and an additional $6,000 for catch-up over age 50).
The dual funding source is what makes the individual 401(k) attractive. Less income is needed to fully fund the account than is needed to fully fund the SEP IRA. This translates to a greater tax deduction.
Because individual 401(k) plans allow salary deferrals, they also allow Roth salary contributions. These contributions are made with after-tax dollars and are a way to set aside funds that can be distributed tax-free in retirement. I cover this information in detail in another article.
Many people are not eligible to make Roth IRA contributions due to their income exceeding the IRS threshold. However, with individual 401(k) plans (and traditional 401(k)s) there is no income limit. This means someone who was excluded from contributing to a Roth IRA can contribute to a Roth 401(k). (For related reading, see: Roth IRAs: Eligibility Requirements.)
There are always trade-offs. It is important to remember that amounts you contribute via Roth are not deductible. You need to consider whether building a tax-free fund for retirement is more important than the immediate tax deduction of traditional contributions. Be sure your individual 401(k) plan allows them. While Roth contributions are allowed per regulations, not all investment providers allow this provision in their plans so choose carefully.
Individual 401(k) vs SEP IRA: Loan Provisions
A common feature of 401(k) plans is the ability to take a loan from your account. Whether it is advisable to take a loan is a separate topic. But like Roth provisions, you will need to be sure that the financial institution you work with allows loans as part of their individual 401(k) plan document.
SEP IRAs, like all types of IRAs, do not allow loans. They do allow for early distributions that are subject to penalties in addition to regular income taxes. There is a back door way to access funds in an IRA for a short period of time. This is known as the 60-day rule. As a result of misuse of this rule and court rulings in favor of the IRS, the rules have become more stringent and these transactions are on their radar.
Individual 401(k) funding deadlines vary depending on source (salary deferral and/or profit sharing) and tax filing status of the business entity (LLC, sole proprietorship, C-corp, S-corp or partnership).
- Salary deferral and employer profit-sharing contribution deadlines for sole proprietorship, partnerships, and LLCs taxed as a sole proprietorship follow the personal tax filing deadline. This is usually April 15 or later if extensions were filed.
- For C-corps, S-corps, and LLCs taxed as a corporation, the salary deferral deadline is usually December 31 of the year the deduction is intended for. Employer profit-sharing contributions are due the following March 15 (plus extensions).
SEP IRA funding deadlines depend on the tax filing status of the business entity.
- Sole proprietorship, partnerships, and LLCs taxed as a sole proprietorship follow the personal tax filing deadline. This is usually April 15 or later if extensions were filed.
- For C-corps, S-corps, and LLCs taxed as a corporation, the deadline is usually March 15 (plus extensions).
The individual 401(k) offers some attractive advantages but has the potential to lead to greater complexity and cost. The SEP IRA in comparison is much more straightforward but in an effort for simplicity, the SEP IRA might leave one shortchanged.
It’s not about which one is better. It’s about which one makes sense for you. In either case, these retirement accounts offer substantial tax savings and are much more robust than typical IRA and Roth IRA investments. Don’t get too caught up in the debate. If you’re self-employed with no employees and you don’t have either, get started!
(For more from this author, see: How to Make Your Own Retirement Fund.)