There are very few slam dunks in this industry, but choosing an Independent 401(K) (also known as an Independent 401(k) or solo-401(k)) over the SEP IRA is clearly one of them. If you are a sole proprietor and you want to maximize retirement contributions with the lowest cost and highest flexibility, check out five reasons why the Individual 401(K) may be a good fit for you. (For background reading, see 401(k) Plans for the Small Business Owner.)
Advantage No.1: Maximum Pretax Contributions
The advantage of the Individual 401(k) is that the maximum pretax contributions are higher at every level of net earnings before qualified plan deductions for the Individual 401(k) than the SEP IRA. Figure 1 shows the maximum contributions at varying income levels and illustrates that the difference between the two can be considerable.
For example, at $50,000 of net earnings, an individual can contribute up to $31,293 to the Individual 401(k) while the SEP IRA is maxed out at only $9,293. That is a $22,000 difference in favor of the Individual 401(k). Figure 2 shows that Individual 401(k) maximum contributions far exceed those for the SEP IRA until net earnings surpass $175,000. At that point, the difference decreases but is still in favor of the Individual 401(k) by $5,500 at the maximum allowable amounts. This is because the Individual 401(k) has the catch-up provision for individuals over 50 while the SEP IRA does not.
|Net Earning Before Qualified Plan Deductions||Max Independent 401(k) Contribution||Max SEP IRA Contribution||Independent 401(k) - SEP IRA|
The Independent 401(k) beats the SEP IRA for the maximum plan contribution no matter what the 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. You also should remember that this difference is going to happen each year so it can mean the difference between hundreds of thousands of dollars in your retirement plan over the course of your career.
Advantage No.2: Contributions Are Discretionary and Loans Are Allowed
Independent 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 the 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 have 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. (For more insight on this option, read Sometimes It Pays to Borrow From Your 401(k) and 8 Reasons to Never Borrow From Your 401(k).)
Advantage No.3: Ease, Low Cost and Flexibility
Both the Individual 401(k) and SEP IRA are easy to open and manage. If opened at a discount broker, it is possible to have practically no cost other than trading. Both are extremely flexible when it comes to investing. In addition, as of 2010, neither the individual 401(k) nor the SEP IRA requires that you file Form 5500 with the Internal Revenue Service provided your plan contains less than $250,000 worth of assets.
Advantage No.4: Roth Conversion Strategy
Another notable advantage of the Individual 401(k) is that unlike the SEP IRA, it is not considered when evaluating 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 another traditional IRA with $75,000, $30,000 of which is 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 ordinary income. Why? Because the IRS requires you to pro-rate 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 and you still have the traditional IRA with $75,000, $30,000 of which is 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* (1-0.40)) compared to the example with the SEP IRA in which you would have recognized $62,250 ($75,000*(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 be 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 this an essentially tax-free Roth conversion. (For more insight, see The Simple Tax Math of Roth Conversions.)
Advantage No.5: Roth Individual 401(K)
If you are in a low tax bracket today and would prefer to pay the taxes but are still interested in maximizing your retirement savings, you can elect to have the employee salary deferral portion contributed after-tax into a Roth Individual 401(k) while the employer contribution is 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 making contributions to a SEP IRA, you should know that the deadline to open an Individual 401(k) is December 31, as opposed to a tax filing for the SEP IRA. If you are a sole proprietor, consider opening up an Individual 401(k) today.