If you’re a business owner, you have the option to open a SEP IRA or 401k at your company. These accounts can only be opened by a business owner; employees cannot establish a 401k or SEP IRA on their own, like they could with an IRA.
The main difference between the two accounts is that a business owner will usually set up a SEP IRA for their own retirement savings, while a 401k would be established in order to offer retirement benefits to their employees. A SEP IRA can also be offered to employees, as it’s cheaper and simpler to administer than a 401k. However, due to how SEP IRA contributions work, it can get more expensive if a business owner has too many employees.
We’ll discuss all the differences and things to consider between the two accounts below.
How a SEP IRA works
Any business owner can set up a SEP IRA for themselves and for their employees. When you own a business or become self-employed, you become eligible for business retirement plans not available to individuals. Instead of being limited to contributing to just a traditional or Roth IRA, you can open a SEP IRA or even the superior solo 401k.
A SEP IRA allows business owners to contribute up to 25% of their compensation up to a maximum of $61,000 for 2022 and $66,000 for 2023. With a 401k, employees are allowed to make contributions into their own plans. With a SEP IRA, only employers are allowed to contribute; employees can only receive contributions from their employer.
The equal percentage contribution rule
If you have any employees as a business owner, you’re required to make equal percentage contributions for every eligible employee. For example, if you contribute 10% of your compensation into your SEP IRA, you must also contribute 10% of every eligible employee’s compensation into their SEP IRAs.
This makes the SEP IRA a costly choice if you have too many employees. For example, if you have over 100 employees, you’ll have to make contributions to 100 different SEP IRAs in order to contribute to your own SEP IRA. For this reasons, the SEP IRA is best for employers with just a handful of employees.
Who is an eligible employee?
Any employee over 21 years of age who worked for your business at least 3 out of the last 5 years, and earned at least $650 in 2022 and $750 in 2023.
What if I have zero employees?
If you have zero employees, you can still set up a SEP IRA for yourself and contribute up to $61,000 for 2022 and $66,000 for 2023. However, having no employees means you’re also eligible for a solo 401k, which offers even more benefits than a SEP IRA.
How a 401k works
A SEP IRA is mainly set up by business owners to prioritize their own retirement savings. A 401k, on the other hand, is mainly set up in the interest of their employees. Offering a 401k plan isn’t a requirement by the IRS, but companies do so to as an employee benefit so that they could attract and retain top talent.
With a SEP IRA, employees are not allowed to make contributions on their own; they can only receive contributions made by their employer. With a 401k, employees are allowed to contribute up to 100% of their compensation up to $20,500 ($27,000 if age 50+) for 2022 and $22,500 ($30,000 if age 50+) for 2023.
This makes the 401k plan much more attractive than a SEP IRA for employees. They’re able to deduct their contributions from their taxable income if contributing to a traditional 401k. If a Roth account is also offered, employees can contribute in after-tax dollars and enjoy tax-free withdrawals in retirement. A SEP IRA has no Roth option.
The downside of a 401k for employers is that it’s much more expensive to set up and maintain, and requires more administration work. A SEP IRA has no annual tax filings and comes with minimal administrative duties. A 401k requires annual tax filings with the IRS, multiple notices each year for participants, payroll deductions every pay period, annual non-discrimination testing, and potential plan audits by the IRS or Department of Justice.
With a SEP IRA, all contributions to employee accounts are made by the employer. With a 401k, employers are not required to contribute to employee accounts, but can choose to offer employer matching contributions as an added incentive.
The structure of 401k matches can be customized, but are usually anywhere between 3 to 6 percent of an employee’s salary. For example, you could decide to offer dollar-for-dollar 401k match up to 5% of compensation. If an employee makes $100,000 at your company, and they contribute $10,000 to their 401k, your employer match would be $5,000. This amount would get contributed to the employee’s account and can either be vested immediately or after several years of service.
Also read: Companies With The Highest Employer Matches
Key differences between a 401k and SEP IRA
Here are the main differences between a SEP IRA and 401k.
Employers can choose whether to open a SEP IRA or 401k. Employers might decide to open a SEP IRA in order to contribute to the plan themselves. They may also choose to open a SEP IRA if they used to have a solo 401k, but hired at least one full-time employee and are no longer eligible. A 401k is mainly offered to offer retirement benefits to their employees. Usually, only larger companies will set up a 401k plan because they’re more costly to set up and maintain, and has more administration duties than a SEP IRA.
Employees cannot open a SEP IRA or 401k on their own. If they work for a company that sponsors a 401k, they’re eligible to make contributions into the plan. If they work for a company that offers a SEP IRA, they cannot make contributions directly and can only receive contributions made by their employer.
A 401k plan has the most limited investment options out of any retirement plan. Employees can only invest in whatever options are provided by their employer’s plan provider. Usually, it’s just a list of 8 to 12 mutual funds.
A SEP IRA has a much wider range of investment options. You can invest in individual stocks, mutual funds, ETFs, and bonds.
A SEP IRA and 401k both have the same contribution limits. However, a 401k also has catch-up contributions for people who are at least 50 years of age.
401k contribution limit: The 401k contribution limit is $61,000 for 2022 and $66,000 for 2023. If you’re at least 50 years of age, you also get catch-up contributions, bringing your total limit to $67,500 for 2022 and $73,500 for 2023.
SEP IRA contribution limit: The SEP IRA contribution limit is also $61,000 for 2022 and $66,000 for 2023. There are no catch-up contributions if you’re 50 or older.
With a 401k, contributions are separated by employer and employee contributions. Out of the $61,000 limit for 2022, employees can contribute up to $20,500 ($27,000 if age 50+). Out of the $66,000 limit for 2023, employees can contribute up to $22,500 ($30,000 if age 50+).
With a SEP IRA, contributions are made entirely by employers only. Employers can contribute up to 25% of their compensation up to the contribution limit for the year.
A 401k can come with two different options: a traditional 401k and a Roth 401k.
- Contributions to a traditional 401k are made in pre-tax dollars. You get a tax deduction for your contribution, but withdrawals in retirement are taxed as regular income.
- Contributions to a Roth 401k are made in after-tax dollars. You don’t get any upfront tax benefits, but withdrawals in retirement are tax-free.
Not all companies offer a Roth version of the 401k. If they do, employees can choose which accounts to contribute to each year. A SEP IRA has no Roth option; all contributions must be made in pre-tax dollars.
A 401k lets you take out a loan from your account, while there is no such thing as a SEP IRA loan. With a 401k, you’re allowed to borrow up to 50% of your plan’s value, up to a maximum of $50,000. You’ll have 5 years to pay yourself back, and interest rates are set at prime rate plus one or two percent.
Business owners who have a SEP IRA and want to take out a loan could look into rolling over their SEP IRA into a solo 401k. A solo 401k has many more tax advantages than SEP IRA, including a Roth option, more investment options, and the ability to take out a solo 401k loan (which works the same way as a 401k loan).
Will I need to pay taxes for taking a 401k loan?
No. Taking out a 401k loan is not a taxable event. However, if you fail to repay the money by the deadline, the loan could be treated as a distribution and you could owe income taxes. If you’re under the eligible withdrawal age of 59½, you may also have to pay an early distribution penalty of 10%.
A 401k match isn’t a requirement but many employers will offer it as an added benefit to make their 401k plan more attractive to potential employees. If a 401k match is offered, the employer will match and employee’s contributions up to a percentage of their salary.
A SEP IRA does not have matching contributions because employees are not allowed to contribute to a SEP IRA.
Equal percentage contributions
Rather than matching contributions, a SEP IRA has equal percentage contributions. As an employer, you can contribute up to 25% of your compensation up to $61,000 for 2022 and $66,000 for 2023. When you make contributions to your SEP IRA, you’re obligated to make equal percentage contributions for every eligible employee at your company.
A 401k does not have this feature. Employees make their own contributions and may receive 401k match contributions, but employers are not obligated to contribute to employees’ accounts.
The withdrawal rules of a 401k and SEP IRA are the same. You must be at least 59½ years old in order to start taking qualified distributions without penalties. Early withdrawals are subject to a 10% penalty plus income taxes on the amount withdrawn.
Since a SEP IRA does not have a Roth option, all contributions were made in pre-tax dollars. Therefore, withdrawals from a SEP IRA will always get taxed as regular income.
Qualified withdrawals from a traditional 401k are taxed as regular income and withdrawals from a Roth 401k are tax-free.
Required minimum distributions (RMD)
Both the SEP IRA and 401k (traditional and Roth) have required minimum distributions. You’re required to start taking distributions from your account when you reach the age of 72. You must take your RMD each year until it’s emptied. You can refer to the RMD table to calculate your RMD amounts.
The only retirement account without an RMD rule is a Roth IRA.