I am self-employed, and my company does not have any employees. Occasionally, my spouse will help out with various projects but does not work for the company full time. It is likely that I will add an employee later this year or next year.
I want to start a retirement plan. Which is the better option for me—a SEP or a 401(k)?
This question gets that dreaded catch-all answer—it depends. There are several key factors to be considered:
- Type of entity, e.g. sole proprietorship, S corporation, etc.,
- Your compensation from the business,
- Total amount you wish to save, and
- Your willingness to make contributions for employees (if/when you hire them).
These factors can be interrelated, but we will touch on each one briefly here.
Entity Type and Compensation
Regardless of plan type, contributions are based on the eligible compensation of each participant. This is where entity type matters. In a sole proprietorship or partnership, your compensation for retirement plan purposes is your earned income from the business up to a maximum of $275,000 (as indexed for inflation). Earned income is basically your net profit with certain adjustments for self-employment tax. In a corporation (either S or C), plan compensation is limited to W2 pay. So, in an S Corporation, year-end distributions of profits do not count for plan purposes. That makes it important to work with a tax advisor to determine the best overall strategy for apportioning your compensation between W-2 and S-Corp distributions.
Compensation and Overall Savings Target
In a SEP, the only contributions allowed are company profit sharing contributions, and the total is capped at 25% of eligible compensation. A 401(k) plan allows employee salary deferrals as well as company-funded matching and profit sharing contributions. While those company contributions are still capped at 25% of pay, employee deferrals are allowed up to 100% of pay. We should also note that the total contributions made by or on behalf of any individual employee cannot exceed 100% of his or her pay.
Let’s assume your plan compensation for the year is $100,000. The maximum you could save in a SEP is $25,000 (25% of pay); however, you could save a total of $43,500 in a 401(k) plan ($18,500 in employee deferrals + $25,000 in profit sharing). If you are age 50 or older, you could save an additional $6,000 in catch-up contributions in a 401(k) for an overall total of $49,500.
Savings Target and Contributions for Employees
SEPs and 401(k) plans have different rules for plan eligibility for new employees as well as how they must be treated once in the plan. In a SEP, any employee who has earned at least $600 in pay (indexed for inflation) in three of the preceding five years must be eligible for the plan. With a 401(k) plan, the maximum eligibility requirement is attainment of age 21 and completion of one year of service, defined as 12 months of service in which the employee works at least 1,000 hours.
So, a SEP allows you to keep new hires out for up to three years, but then pretty much anyone becomes eligible no matter how few hours they work for you each year. With a 401(k), you can only make people wait a “year,” but unless the person works at least 20 hours per week on average, he or she is never deemed to have met that one-year wait. That means the length of employment and the number of hours worked each year drive when a new hire joins the plan.
Once in the plan, a SEP must provide the same contribution (as a percent of pay) to everyone. So, if you contribute 25% for yourself, you must also contribute 25% for anyone else who is eligible, including your spouse and/or other employees. 401(k) plans allow varying treatment of different people, subject to a set of annual nondiscrimination tests that ensure the variations are not too extreme. Each eligible participant must be allowed to make salary deferrals, but it is up to each one how much they wish to save. The plan can be written so that everyone receives the same profit sharing contribution or that each person can receive differing amounts.
As you can see, there isn’t a quick one-size-fits-all answer, but DWC’s team of experts is always available to review the specifics of your situation and help you choose the best type of plan for you. Just drop us a line here— we are glad to help.