Plan now, so you may borrow against your IRA.
Selecting the right retirement plan can be confusing and the subtle differences between options can sometimes be overlooked.
f you are a self employed individual or an owner and spouse business and are considering a SEP IRA or Individual 401k reading this information should help you make your decision easier by explaining the differences simply.
The SEP IRA and Individual 401k are the two most common retirement plans chosen by successful self employed individuals and owner and spouse businesses due to their high contribution limits and flexible annual contributions. Individual 401k plans have greater administrative responsibilities than a SEP, but may allow a larger annual contribution at identical income levels due to the way the annual contribution is calculated.
Another issue to consider is whether you’d like to have the option of borrowing against your retirement plan by using your retirement plan's balance as collateral and receive an Individual 401k loan. IRS rules do not permit a loan in a SEP IRA, but an Individual 401k loan of up to half of the plan's value up to a $50,000 maximum is allowed.
- Features: 2018 SEP IRA contribution limit is $55,000.
- Advantages: Easy to setup and low administrative responsibilities.
- Disadvantages: An Individual 401k may provide a larger contribution and tax deduction compared to a SEP IRA. For those age 50+ there isn't an additional $6000 catch-up contribution provision like there is with the Individual 401k.
Simply, the SEP IRA is a great choice for self employed individuals or owner and spouse businesses who would like to contribute up to 25% of their W-2 earnings or 20% of net self employment income up to the SEP IRA contribution limit. A SEP provides high maximum contribution limits, but an Individual 401k may allow a greater contribution at the same income level.
A final point to consider is IRS rules do not permit loans with a SEP IRA. A SEP IRA is the right choice if you aren't in need of a loan and don't anticipate needing one in the future.
It is important to note that you can set up a SEP IRA and convert to an Individual 401k in the future if you change your mind and either want to receive an Individual 401k loan or if you want to contribute more than the calculations of a SEP IRA will allow. Converting from a SEP IRA to an Individual 401k and transferring retirement assets from a SEP IRA to a new Individual 401k can be accomplished by completing some minor administrative paper work.
If this sounds like you then keep it simple and set up a SEP IRA.
Features: 2018 Individual 401k contribution limit is $55,000 ($61,000 if age 50 or older due to a "catch-up" provision).
Advantages: Potentially greater retirement contributions at identical income levels compared to a SEP IRA. Individual 401k loans are permitted up to 50% of the total 401k value with a $50,000 maximum.
Disadvantages: Potentially greater administrative responsibilities and administrative fees compared to a SEP IRA.
Who would be appropriate for an Individual 401k?
The Individual 401k and the SEP IRA have comparable maximum limits, but due to the way the contribution is calculated a self employed individual may be able to contribute more into an Individual 401k versus a SEP IRA at the same income level, therefore maximizing retirement contributions and valuable tax deductions.
Here's how the calculation works. In 2018 participants in an Individual 401k can contribute up to 100% of the first $18,500 ($24,500 if age 50 or older) of W-2 compensation or net self employment income for a sole proprietorship. In addition, a profit sharing contribution can be made up to 25% of W-2 wages or 20% of net self employment income. The contribution limit calculation in an Individual 401k is important because it allows you to potentially save more than a SEP IRA at the same income level.
To determine how much you can contribute based on your income use the interactive Individual 401k calculator.
Another important distinction between the SEP IRA versus the Individual 401k is the loan feature. An Individual 401k loan may be considered a valuable feature to some self employed business owners.
Learn more about an Individual 401k loan
For many successful business owners the decision of which retirement plan to choose comes down to either a SEP IRA or Individual 401k. Simply stated there are 2 primary advantages of the Individual 401k over the SEP IRA.
1. Potentially greater retirement contributions at the same income level, therefore maximizing retirement contributions and valuable tax deductions.
2. The option of a tax free loan using the balance of the plan as collateral via an Individual 401k loan.
If you value the loan feature or want to maximize your annual retirement contributions then you should consider an Individual 401k. If not, the simplicity of a SEP IRA makes it the best choice for you.
Note: Consider a defined benefit plan as an alternative to a SEP IRA or Individual 401k if you are self employed and would like to contribute more than the SEP IRA and Individual 401k contribution limits. Contributions to a defined benefit plan are dependent on an individual’s age and income, but can potentially be $60,000 to $200,000 or more a year. We provide more information about them on our website www.definedbenefitplan.com.