|Net Earnings Before Qualified Plan Deductions||Max Individual 401(k) Contribution||Max SEP IRA Contribution||Individual 401(k) – SEP IRA|
The individual 401(k) beats the SEP IRA for the maximum plan contribution regardless of your net earnings—unless you’re a very high earner. For sole proprietors living in states with high income-tax and those with additional outside sources of income, this could mean the difference between a refund and a bill when it comes time to do your taxes. Moreover, because this difference will occur each year, it can put hundreds of thousands of extra dollars in your retirement plan throughout your career.
2. Contributions Are Discretionary; Loans Are Allowed
Individual 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 if their business takes a turn for the worse. In addition, owners may be able to take loans for as much as $50,000 or 50% of the value of the benefits in the plan (whichever amount is lower).
Although the SEP IRA doesn’t require mandatory contributions, it has no such loan provisions. The ability to take a tax-free loan from your individual 401(k) in the case of an emergency should be taken seriously because sole proprietors often have variable incomes from year to year.
3. Ease, Low Cost, and Flexibility
Individual 401(k) accounts are easy to open and manage. If you open one at a discount broker, you may incur practically no costs other than those included in trading. They are also highly flexible when it comes to investing. In addition, you are not required to file Form 5500 with the Internal Revenue Service, provided your plan contains less than $250,000 worth of assets. This is true for both individual 401(k) plans and SEP IRA plans.
4. Less-Expensive Roth Conversions
Suppose you have a SEP IRA with $100,000 and a traditional IRA with $75,000 ($30,000 of which represents 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 your ordinary income. This is because the IRS requires you to prorate 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, plus the traditional IRA with $75,000. Again, $30,000 of that amount represents nondeductible contributions. If you convert your total traditional IRA worth $75,000, you could exclude 40% ($30,000 / $75,000) of the conversion from ordinary income, as 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 x (1 – 0.40)) compared to the example with the SEP IRA, in which you would have recognized $62,250 ($75,000 x (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 represent nondeductible contributions. In this case, it is possible to convert the $30,000 traditional IRA and exclude 100% of the conversion from ordinary income, making it an essentially tax-free Roth conversion.
If you will be in a higher tax bracket when you retire, consider funding an individual Roth 401(k).
5. The Option to Elect Roth Contributions
If you are in a low tax bracket today and would prefer to pay the taxes now, you can elect to have the employee salary deferral portion of your 401(k) contributed after-tax into a Roth individual 401(k). The employer must still contribute before tax as with a traditional Individual 401(k). The SEP IRA does not have this option.
Can I Have a 401(k) as a Sole Proprietor?
Yes you can have a 401(k) if you own your business and are the only employee. This is called a solo or individual 401(k).
How Much Can a Sole Proprietor Contribute To a 401(k)?
You can contribute $22,500, plus 25% of your compensation and $6,500 ($7,500 if you’re over 50) up to the maximum amount of $66,000 per year.
How Does a Solo 401(k) Work for a Sole Proprietor?
An individual 401(k) lets a business owner with no employees contribute up to a maximum of $66,000 in 2023.
The Bottom Line
In many cases, the individual 401(k) is a better alternative to the SEP IRA for sole proprietors. If you are accustomed to making annual contributions to a SEP IRA, note that the deadline to open an individual 401(k) is Dec. 31, as opposed to the SEP IRA, which you have until April 15—or an adjusted tax day because of a weekend—of the following year to fund.