SEP IRA vs 401k: Which is the best plan in 2022?

Planning for retirement is a task that is not worth procrastinating. We know you have plenty of options. So in this post, we take a look at the SEP IRA vs 401k. Let the battle begin.

Your biggest advantage that you have in planning for retirement, is time.  Whether you’re near retirement or a newly graduated high school student, there are plenty of options to consider to ensure you take the best options possible for retirement.

Among the many retirement options are qualified benefit plans offered by most employers.  You may have heard of a 401(k), Cash Balance Plan, or SEP (Self Employed Pension plan) among the many retirement vehicle options.  But the biggest question is, which one is right for you?  And is one better than another?

Here is a deep dive report on the important pieces of information concerning qualified retirement plans like 401(k) plans, Cash Balance Plans and SEP plans.

SEP IRA vs 401k: Some Background

The main differences between the three retirement vehicles mentioned above, are going to be the tax benefits and who they are designed to work for.

To put it simply, a 401(k) plan is a retirement account offered by employers allowing employees of the company to contribute a portion of their paycheck to retirement.  Cash Balance Plans and SEP plans, however, are designed mainly for small business owners and corporate executives.

Comparing Cash Balance Plans to 401k and SEP

There are benefits that each offer, that may be worth noting when deciding which is right for you. Below is a brief description about each plan, along with key points to consider as we take a look at the SEP IRA vs 401k.

401(k) Retirement Plans

A 401(k) plan is a retirement account offered by employers. Employees of the company are allowed to contribute a percentage of their paycheck to a 401(k) plan that is later disbursed to them in retirement.

The funds of a 401(k) plan are invested in the stock market as directed by the employee. In most cases, the employee has multiple options of mutual funds to choose from when deciding on investing their contributed money.

Funds are not to be withdrawn from a 401(k) until said employee reaches at least the age of 59 ½. If funds are withdrawn before this age, a 10% penalty is applied, and the funds withdrawn are taxed as ordinary income. The reason for the penalty is to encourage people to save for retirement and not withdraw the funds until the stated retirement age.

Traditional 401(k) plans also have tax advantages. Any funds contributed to a 401(k) are not taxed until withdrawn in retirement. This is called “tax-deferred”, or, taxes are deferred being paid until retirement. The benefit of a tax deferred retirement account is that they grow on a tax deferred basis as well. Any growth on your initial investment is not taxed until retirement.

Compare Cash Balance Plans to 401k and SEP

Self-Employed Pension Plans (SEP)

Often referred to as SEP IRA’s, Self-Employment Pension Plans are essentially a type of traditional IRA for self-employed individuals or small business owners.  They function like a traditional IRA in how funds are invested.  You have your choice of investments depending on which investment company you use to open the account.

The benefit of a SEP over a regular traditional IRA is that you can take advantage of higher contribution limits than an IRA offers. IRA’s only allow a yearly contribution of $5,500 for individuals, or $11,000 for spouses, where SEP plans allow you to contribute up to $55,000 yearly.

Small businesses with one or more employee can open a SEP IRA account at their. Owners of the small business can also offer a SEP IRA to their employees, and contribute up to 25% of the employees compensation to the account, allowing a small business to offer 401(k) like benefits.

Cash Balance Plans

A cash balance pension plan has often been described as a “defined benefit plan with a 401(k) twist.”  It is a plan that is similar to a 401(k), but has a higher contribution limits than a traditional 401(k). It allows sizable contributions and big tax deductions.

Keep in mind that cash balance plans also allow you to take advantage of a 401(k) as well as contribute to your Cash Balance Plan.  This is what we call a combo plan. This makes for an enticing benefit for small business owners and corporate executives with ownership interest.

Traditional 401(k)’s have contribution limits of $19,500 (as of this writing) per year, where a cash balance plan allows you to contribute much more.  There is not a specific numerical number on the limit because it is age dependent.

Employees who may be closer to retirement age have higher contribution limits, allowing them to “catch up” on contributing to retirement funds. These contribution limits will be specified in the Cash Balance Plan documents.

Small business owners may benefit more from a Cash Balance Plan because of the age dependent contribution limits. Many business owners will want to reinvest the majority of the business revenue in its initial growth years, not allowing the owner to contribute to retirement in the beginning years of the business. A cash balance plan will allow a business owner in this scenario to contribute more in later years of the business as growth and revenue matures.

How to set up a retirement plan and have the IRS pay for it

You may be able to claim a tax credit for some of the ordinary and necessary costs of starting a SEP, SIMPLE IRA or qualified plan. A tax credit reduces the amount of taxes you may owe on a dollar-for-dollar basis.

Sketch of retirement plans

If you qualify, you may claim the credit using Form 8881, Credit for Small Employer Pension Plan Startup Costs.

Eligible employers
You qualify to claim this credit if:

  • You had 100 or fewer employees who received at least $5,000 in compensation from you for the preceding year;
  • You had at least one plan participant who was a non-highly compensated employee; and
  • In the 3 tax years before the first year you’re eligible for the credit, your employees weren’t substantially the same employees who received contributions or accrued benefits in another plan sponsored by you, a member of a controlled group that includes you, or a predecessor of either.

Amount of the credit
The credit is 50% of your ordinary and necessary eligible startup costs up to a maximum of $500 per year.

Eligible startup costs
You may claim the credit for ordinary and necessary costs to:

  • Set up and administer the plan, and
  • Educate your employees about the plan.

Eligible tax years
You can claim the credit for each of the first 3 years of the plan and may choose to start claiming the credit in the tax year before the tax year in which the plan becomes effective.

How to determine what is better: SEP IRA vs 401k

  • When are you establishing the plan? A SEP can be opened up and funded before the date the tax return is filed (including extensions). However, a 401k must be set up by the end of the year.
  • How much do you want to fund? You can get a little more into a 401k than a SEP. A SEP acts like a profit sharing plan, but a 401k can have a profit sharing component in addition to the deferral.
  • Consider future contributions. Will you need to fund larger contributions in future years? This might result in the 401k being the best choice.
  • Annual IRA compliance. Don’t forget that you will have to file a form 5500 with the IRS when your 401k balance exceeds $250,000. SEPs are excluded from this rule.
  • Don’t forget a cash balance plan. 401ks and SEPs are great but just don’t allow the huge contributions offered by cash balance plans. Talk to your financial advisor and determine what plan is best for you.

SEP IRA vs 401k: The Decision

So in the battle of the SEP IRA vs 401k there are many pros and cons.

Whether you are an employee of a large company, small company, or a self-employed individual or owner of a small business, there are retirement vehicles designated for your unique scenarios.  Determine what your objectives are and take advantage of the potential tax benefits and savings benefits offered by retirement vehicles.

Paul Sundin

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