As a sole proprietor, you can generally choose between two kinds of tax-advantaged plans — the
SEP IRA and the
individual 401(k) — to save for retirement. If your goal is simplicity and ease of administration, the SEP (Simplified Employee Pension) may be the answer. Otherwise very similar to a Traditional IRA, the SEP offers two key differences: more generous limits on annual contributions and the fact that only employers, or sole proprietors, can make contributions under the plan. If you want to go a different route that offers additional flexibility and the ability to maximize contributions with pre-tax salary deferrals as well as the potential to borrow from the plan, an individual
401(k) could be better.
The chart below can help you compare at a glance the advantages — and limitations — of each.
Retirement plans at a glance: Individual 401(k) vs. SEP IRA |
| |
Individual 401(k) |
SEP IRA |
| Employer contributions are generally tax deductible by business |
Yes |
Yes |
| Plan expenses are generally tax deductible by business |
Yes |
Yes |
| Employer contributions are flexible |
Yes |
Yes |
| Business owners contribute as employees |
Yes |
No |
| Roth (after-tax salary deferrals) option |
Yes |
No |
| Plan loans available |
Yes |
No |
| Investment choices |
Menu of funds and model portfolios |
Broad range of investments |
| Additional IRS filing required |
Sometimes |
No |
| Annual dollar limits on contributions for participants under age 50 |
$57,000 for 2020 |
$57,000 for 2020; $56,000 for 2019 |
| Annual dollar limits on contributions for participants age 50 or older |
$63,500 for 2020 |
$57,000 for 2020; $56,000 for 2019 (catch-up contributions are not permitted) |
"The SEP offers two key differences from a traditional IRA: more generous limits on annual contributions and the fact that only employers, or sole proprietors, can make contributions under the plan."
— Judith Anderson, Senior Vice President, Retirement & Personal Wealth Solutions at Bank of America
Sole proprietors can normally sock away up to 20% of their net earnings from self-employment (as determined under the
SEP IRA rules)
Footnote 1 — generally, your business's net profit minus the deductible portion of your self-employment tax — up to a maximum of $57,000 for 2020 ($56,000 for 2019).
For example, if your net earnings from self-employment are $150,000, you can contribute up to $30,000 for 2019 as well as for 2020. See Deduction Worksheet for Self-Employed in IRS Publication 560, Retirement Plans for Small Business.
As with a
SEP IRA, you can make an
employer's contribution, generally capped at 20% of your net earnings from self-employment. In addition, you can also make an
employee's contribution of up to $19,500 for 2020, as well as $6,500 in catch-up contributions for individuals who are age 50 or older at any time during the year. The total combined contributions, not counting catch-up contributions, can't exceed $57,000 for 2020.
Thus, if your net earnings from self-employment in 2020 are $150,000 and you're under age 50, you can make a maximum employer contribution of $30,000 — plus an employee contribution of $19,500, or $49,500 total.
Your contributions and plan expenses are generally tax-deductible. Distributions are taxed as income. Withdrawals before age 59½ are normally subject to an additional 10% federal tax.
An
individual 401(k) can be set up either as a traditional
401(k), with deductible contributions and taxable distributions, or as a Roth individual
401(k), with no deductions for employee salary deferral contributions but distributions that are normally federally tax-free during retirement, provided certain requirements are met. The SEP IRA doesn't offer that flexibility.
The deadline for creating a SEP IRA and for making contributions for a taxable year is your tax filing deadline, generally April 15 unless you file for an extension. You're responsible for administering the plan but won't have to file a report to the IRS.
This plan must be established by the end of the last day of the tax year. Assuming there are no employees, the sole proprietor's contributions must be made by your tax filing deadline, including extensions. Once assets in an individual 401(k) plan reach $250,000, you must comply with the annual IRS Form 5500 filing requirements.