There are very few slam dunks in retirement planning, but choosing an individual 401(k)—also known as a one-participant 401(k) or solo 401(k)—over a SEP IRA can be one of them. If you are a sole proprietor and want to maximize your retirement contributions with the lowest cost and highest flexibility, check out these five reasons an individual 401(k) may be right for you.

Key Takeaways

  • You can contribute considerably more to an individual 401(k) than to a SEP IRA.
  • Individual 401(k)s allow for loans, while SEP IRAs do not.
  • Having an individual 401(k) instead of a SEP IRA can also make Roth IRA conversions less expensive.

Advantage No. 1: Maximum Pretax Contributions

A key advantage of the individual 401(k) is that the maximum amount you can contribute is higher at every level of net earnings than it is for a SEP IRA. The chart below shows the maximum contributions you could make at varying income levels and illustrates that the difference between the two can be considerable.

For example, at $50,000 of net earnings, you could contribute as much as $34,294 to an individual 401(k), while the SEP IRA maxes out at only $9,294 (as of 2019). That is a $25,000 difference in favor of the Individual 401(k).

The next chart shows that individual 401(k) maximum contributions continue to exceed those for the SEP IRA by $25,000 until net earnings reach $200,000. At that point, the difference decreases, but it's still in favor of the individual 401(k). These maximums assume you're eligible for the catch-up provision for anyone 50 and over, which allows you to contribute an additional $6,000 to a 401(k); the SEP IRA has no catch-up provision.

Net Earnings Before Qualified Plan Deductions Max Individual 401(k) Contribution Max SEP IRA Contribution Individual 401(k) - SEP IRA
$50,000 $34,294 $9,294 $25,000
$75,000 $38,940 $13,940 $25,000
$100,000 $43,587 $18,587 $25,000
$125,000 $48,234 $23,234 $25,000
$150,000 $52,950 $27,950 $25,000
$175,000 $57,883 $32,883 $25,000
$200,000 $62,000 $37,816 $24,184
$225,000 $62,000 $42,749 $19,251
$250,000 $62,000 $47,683 $14,317
$275,000 $62,000 $52,616 $9,384
$300,000 and over $62,000 $56,000 $6,000

The individual 401(k) beats the SEP IRA for the maximum plan contribution no matter what your net earnings. For sole proprietors living in high income-tax states and for those with additional outside sources of income, this difference could be the difference between a refund and a bill at tax time. It's also worth remembering that this difference is going to happen each year, so it can put hundreds of thousands of extra dollars in your retirement plan over the course of your career.

Advantage No. 2: Contributions Are Discretionary and Loans Are Allowed

Individual 401(k) contributions are not mandatory every year. This allows sole proprietors to manage their cash flows and contribute the maximum amount in good years while contributing less or nothing at all should business take a turn for the worse. In addition, owners can take loans of up to $50,000 or 50% of the value of the benefits in the plan, whichever is lower.

While the SEP IRA doesn't require mandatory contributions, it has no such loan provisions. The ability to take a tax-free loan from your individual 401(k) in cases of an emergency shouldn't be dismissed as trivial, as sole proprietors often have extremely variable incomes from year to year.

Advantage No. 3: Ease, Low Cost, and Flexibility

Both the individual 401(k) and SEP IRA are easy to open and manage. If you open one at a discount broker, you may incur practically no costs other than for trading. Both are also extremely flexible when it comes to investing. In addition, neither the individual 401(k) nor the SEP IRA requires that you file Form 5500 with the Internal Revenue Service, provided that your plan contains less than $250,000 worth of assets.

Advantage No. 4: Less-Expensive Roth Conversions

Another notable advantage of the individual 401(k) is that unlike the SEP IRA, it is not considered in determining the pro-rata cost for a Roth conversion. Let's look at an example.

Suppose that you have a SEP IRA with $100,000 and a traditional IRA with $75,000, $30,000 of which represents nondeductible contributions. If you convert your total traditional IRA worth $75,000, you would only be able to exclude roughly 17% ($30,000 / $175,000) of the conversion from your ordinary income. Why? Because the IRS requires you to prorate the nondeductible contributions across your entire IRA balances including the SEP IRA.

Now, let's say that instead of having the SEP IRA you have an individual 401(k) with $100,000, plus the traditional IRA with $75,000, $30,000 of which represents nondeductible contributions. If you convert your total traditional IRA worth $75,000, you would be able to exclude 40% ($30,000 / $75,000) of the conversion from ordinary income since the individual 401(k) is not included in the pro-rata calculation. In both situations, you are converting $75,000 to a Roth IRA, but with the individual 401(k) you pay less in taxes today because you are only recognizing $45,000 ($75,000 x (1-0.40)) compared to the example with the SEP IRA in which you would have recognized $62,250 ($75,000 x (1-0.17)) in taxable income.

You could even take this a step further and move all of the pretax money from the traditional IRA to the individual 401(k). Then you would have $145,000 in the individual 401(k) and $30,000 in your traditional IRA, of which 100% would represent nondeductible contributions. In this case, it is possible to then convert the $30,000 traditional IRA and exclude 100% of the conversion from ordinary income, making that an essentially tax-free Roth conversion.

Expect to be in a higher tax bracket after you retire? Consider funding an individual Roth 401(k).

Advantage No. 5: The Option to Elect Roth Contributions

If you are in a low tax bracket today and would prefer to pay the taxes now, you can elect to have the employee salary deferral portion of your 401(k) contributed after-tax into a Roth individual 401(k). The employer contribution must still be contributed before-tax as a traditional Individual 401(k). The SEP IRA has no such option.

The Bottom Line

In many cases, the individual 401(k) is a better alternative to the SEP IRA for sole proprietors. If you are accustomed to making annual contributions to a SEP IRA, note that the deadline to open an individual 401(k) is December 31, as opposed to the SEP IRA, which you have until April 15 of the following year to fund.