Selecting the right retirement plan as a self-employed person (or a married couple as business owners) can be confusing and differences between options can sometimes be overlooked.
The SEP IRA and Individual 401(k) are the two most common retirement plans chosen by successful self-employed individuals due to their high contribution limits and flexible annual contributions. However, there are key differences that should be considered.
The Individual 401(k) and the SEP IRA have comparable maximum limits. Due to the way the contribution is calculated, a self-employed individual may be able to contribute more into an Individual 401(k) 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 401(k) 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 401(k) is important because it allows you to potentially save more than a SEP IRA at the same income level. The maximum is $55,000 ($61,000 if age 50 or older due to a "catch-up" provision.)
The SEP IRA allows self-employed individuals to contribute up to 25% of their W-2 earnings or 20% of net self-employment income up to the SEP IRA contribution limit. The maximum is $55,000 for 2018.
You should also consider whether you want the option of borrowing against your retirement plan by using your retirement plan's balance as collateral. IRS rules do not permit a loan in a SEP IRA, but an Individual 401(k) loan of up to half of the plan's value up to a $50,000 maximum is allowed.
Finally, Individual 401(k) balances do not count towards your IRA balances when you are making Roth Conversions, whereas SEP IRAs do. You are allowed to make non-deductible IRA contributions each year ($5,500 in 2018, plus $1,000 catch up if age 50 or older). If you do not have a balance in an IRA, you are able to convert the contribution tax free to a Roth IRA. Individual 401(k) plans work well with this back-door Roth strategy.
Although Individual 401(k) accounts have greater administrative responsibilities than a SEP, in many cases if you are self-employed and do not plan on adding employees, the Individual 401(k) is a much better option than the SEP IRA.