How do I Choose Between a SEP IRA and a 401k?

Among the more popular choices of tax-advantaged retirement savings plans available to self-employed Americans are the Simplified Employee Pension Individual Retirement Account (SEP IRA) and the solo 401k plan. Choosing between a SEP IRA and a 401k is a matter of understanding the benefits and features of both plans, as well as a person's own circumstances. A comparison of the two seems to suggest that the solo 401k plan is the more advantageous, but there are multiple features and benefits associated with each plan that blur the issue. For example, although a SEP IRA and a 401k plan have identical tax advantages, the SEP IRA is less costly to maintain, but the 401k permits somewhat greater contributions for the same income level.

The SEP IRA is a simple account to establish at most financial institutions. The costs are low and the investment opportunities the same as the traditional IRA — stocks, bonds, mutual funds, etc. The main difference between the SEP IRA and the traditional IRA is the contribution amount. In 2010, for example, workers under age 50 could contribute 100% of their taxable income to their IRA Accounts, up to a cap of $5,000 US Dollars (USD), while the self-employed of any age with a SEP IRA could contribute up to 25% of their income, up to a cap of $49,000. Highly complex and confusing Internal Revenue Service (IRS) rules make the exact calculation of the allowable contribution a matter for a special calculator; for one thing, the amount of the contribution is based on the total taxable income less the contribution.

A special 401k plan for the self-employed was introduced in 2001 and is commonly called the individual 401k, the solo 401k or the “solo-k.” More costly to establish and maintain than the SEP IRA, it’s restricted to enterprises consisting solely of the owner, or the owner and spouse. Like the SEP IRA, the maximum annual contribution to a solo 401k plan is $49,000 USD for 2010, much higher than the limit for traditional employer-sponsored 401k plans; unlike the SEP IRA, those age 50 and over are permitted a “catch-up” payment, capped for 2010 at $5,500 USD. The IRS allows a wide variety of investment choices for owners of solo 401k plans, although most funds custodians that manage solo 401k plans limit the investment choices available to their clients. Solo 401k owners with specific investment plans for their funds should make sure their funds custodian is prepared to make those investments.

A SEP IRA and a 401k plan, then, have many similarities; they also have some significant differences. Taxes on contributions to a SEP IRA and a 401k, and on their earnings, are deferred until they’re paid out, and both incur significant tax penalties on any amounts withdrawn before age 59½. Contribution limits are essentially the same for those under age 50, and far exceed the contribution limits imposed on traditional IRAs and 401k plans. SEP IRA plans are much less costly to establish and maintain than solo 401k plans. Owners of a SEP IRA may not borrow against those funds, however; owners of a solo 401k plan may borrow up to 50% of the value of their funds, tax-free, with a cap of $50,000. This is a significant difference, especially for those whose businesses mirror the overall economy and find themselves sometimes facing cash-flow problems.