Let’s get something out of the way from the beginning…..both of these plans are good….self-directed or not. But, for someone who wishes to maximize their contributions into a qualified retirement plan, generally speaking the 401K will be a better option. And, please keep in mind that an individual can qualify for a 401K as long as they are self-employed (meaning self-employed with NO employees, other than your spouse). And, for those individuals that are a W-2 employee and have a side business, most do not realize that they can participate in two plans….as long as they do not exceed annual contribution limits. And, both the SEP and 401K can be self-directed…meaning you control the investments from your plan.
As it relates to contributions, one great advantage to the 401K is that the employee (you) can make contributions in both a pre-tax, traditional or after-tax, Roth format. With both the SEP and 401K plan where pre-tax (deductible) contributions are being made, your contributions are tax-deductible and grow tax-deferred until you start taking distributions in retirement years.
However, let’s break down the contribution limits for both.
With your SEP, you make contributions up to 20% of your net self-employment income. So, what is NET income? Net income would be your self-employment income minus half of your required self-employment tax. This 20% threshold allows you up to a total of $50,000 in contributions for 2012.
As with the SEP, you are allowed the same maximum contribution limits…which should lead you to the question of why is the 401K probably better? Well, all contributions to the SEP are based on a percentage of net income, where the 401K allows you to contribute up to 100% of self-employment income through employee deferrals up to $17,000 (2012). Further, the 401K has a “catch-up” provision which allows individuals 50 years and old to contribute (potentially) up to an additional $5,500 for a maximum contribution of $55,500 in 2012. What I said may sound confusing, so let’s use an example.
Let’s use a simple example. Let’s say, just for giggles, that you earned only $10,000 in net income in your business. With your SEP, you would be limited to contributions of $2,000 whereas, if you chose, you could contribute the entire $10,000 into your 401K….also assuming there are no other factors (e.g., W-2 401K employee deferral contributions).
Now, you noticed that I just mentioned the concept of making 401K contributions to both a W-2 and solo (self-directed or not) 401K plan. Most individuals do not know this is permissible, but as long as the individual, employee deferral contributions with both plans does not exceed both under 50 ($17,000/2012) and over 50 ($17,000 + $5,500 catch-up = $22,500/2012) limitations, this is permissible.
Again, as another example:
If you are under 50 and you made contributions to your employer’s plan totaling $10,000 (2012), you could contribute up to an additional $7,000 in employee deferral contributions, as the total contributions between the two plans did not exceed $17,000 (2012). Even under this scenario, one could still contribute up to 20% of their net self-employment income to the 401K plan as long as the total contributions did not exceed your total self-employment earnings for the year.
NOW, ALSO KEEP IN MIND THAT WE HAVE ONLY BEEN TALKING ABOUT CONTRIBUTIONS. WHEN YOU ADD IN FEATURES SUCH AS LOAN PROVISIONS FROM THE 401k THAT THE EMPLOYEE CAN TAKE, THE 401k BECOMES EVEN A MORE POWERFUL TOOL.
One potential drawback to the 401K…since we are past January 1, 2012. If you absolutely want to set up a plan for 2011 contributions, the 401K plan must’ve been established by December 31, 2011. Even though you still have up to April 16, 2012 (regular filing) or September 15, 2012 (late filing) for the accounting of contributions to the plan, the “plan” itself has to be established by December 31 of the year in which you want to make your contributions. The SEP, in comparison, can be open and funded up to April 16, 2012. However, that is probably the only area where the SEP has a true advantage over the 401K.
Please note….and you now know my bias…that I haven’t spoken much regarding self-directed 401Ks and SEPs. While I always preach the benefits of the self-directed model, this post is to compare and contrast 401Ks and SEPs…generally. Just know that with either a SEP or a 401K, you can either make contributions into a “traditional model” SEP or 401K which will only allow you to invest in stocks, bonds and mutual funds OR a “self-directed model” which will allow you to invest in ANY asset that is not excluded by the IRS (which, by the way, allows you to invest in a much, much, wider array of assets….including real estate…with plan assets). The choice is yours.
Remember, as always, this post is to educate and create conversation. It is never intended to replace the assistance you need to secure from your professionals. Bottom line, it is not providing or intending to provide any tax, legal, financial or investment advice.