Please note: This post is only to compare the pros and cons of a SEP (Simplified Employee Pension) vs. a 401K plan for a self-employed individual, who is interested in self-directing their retirement assets. Both plans have definite negatives related to having employees in the plans; however, since we are talking about both plans in relationship to a self-employed individual with NO employees, many of the negatives for both plans are diminished due to the fact that the individual is both the employer and employee. Generally speaking, one could identify the pros and cons of each and, at the end of the day, it would simply depend on your own situation and preference. Both plans have unique benefits and negatives.
Again, we are talking about comparing these plans for a self-employed individual with NO employees, an individual who is either a sole proprietor or incorporated under some entity (e.g., c-corp, s-corp, LLC). The second consideration in comparing the two plans is the common theme that the individual wishes to self-direct his/her retirement funds.
That being said, let’s first look at the 401K and examine its pro’s and con’s.
Pros can be many but, on the surface, can be identified as follows:
- Greater flexibility in contributions vs. other plans;
- Employees can contribute more to these plans than with, for example, an IRA (Traditional, Roth or SIMPLE);
- The 401K is a good plan for any sponsoring business that may have cash-flow issues;
- 401K plans have flexibility in offering both loan provisions and hardship withdrawals;
- Employees can contribute up to $17,000 with an additional “catch-up” contribution of $5,500 for employees over 50 years of age;
- Employers can contribute the lesser of 25% of compensation OR $50,000, whichever is less on top of the employee deferral (assuming, of course, the employee qualifies for such); and,
- The 401K allows for both Employee deferral and Employer match. This provides the option for both to make contributions on a tax-friendly basis.
Cons with the 401K may be viewed as:
- Possible higher administrative costs under more basic arrangements;
- Preparation of an annual Form 5500;
- Requirements to conduct non-discriminating testing so that discrimination is not occurring with a company’s more highly compensated employees; and,
- Additional administrative burdens and costs associated with hardship withdrawals and loan provisions.
Now, remember, we are talking about a self-employed individual who is both the employer and employee of the plan. So, if we were talking about a 401K plan for a company with multiple employees (2 and above), the aforementioned cons would be serious considerations.
However, with an individual 401K plan with NO employees, the following cons are satisfactorily addressed:
- There should be not be higher administrative expenses for the plan for a self-directed individual 401K vs. any IRA. In fact, annual costs can either be eliminated or greatly reduced;
- Provided assets of the plan are under $250,000, there is NO requirement for any reporting of the plans assets, including the Form 5500. Once assets surpass the $250,000 threshold, the individual only has to prepare Form 5500EZ. The Form 5500EZ is the much simpler and prettier cousin of the dreaded Form 5500. It is only two pages long, and the individual or his/her tax preparer can simply prepare this document;
- There is NO non-discrimination testing as, again, the individual is both the employer and employee; and,
- Any hardship withdrawals or loans are executed by the Trustee of the plan…again, typically, the self-employed individual. As such, this does probably not rise to a level of being an administrative burden or cost to the self-directed individual.
So, right now you are probably saying, “Hmm, yes, the 401K is definitely the one to go with…I don’t think I need to read any further.” But, we gotta be fair to the SEP.
So, let’s turn the table and look at the pros and cons of the SEP. Pros of the SEP, can be identified as follows:
- The SEP is easy to set up and operate;
- SEPs have low administrative costs;
- Like the 401K, the SEP has flexible annual contributions…which help with cash-flows issues of a company/sole proprietor; and,
- Employee is vested immediately on the funds contributed on their behalf.
Cons of SEP, could be viewed as:
- The SEP has to fund all employees equally with the same percentage;
- The SEP is an employer funded plan. The employee is not allowed to make contributions nor can they control what the “boss” is doing….the boss sets the contribution limits.
Well, like the 401K, these negatives can be easily addressed by the self-employed individual who has a SEP. Specifically:
- As there is only one employee (typically, just the employer/employee BUT they could also include their spouse), there is not a concern, generally, about funding the contributions in the
same manner as other employees. There are no other employees; and,
- One might say, who cares if the SEP is an employer-funded plan as, again, the employer and employee are the same individual.
Okay, so now you may be leaning a bit more to the SEP. But remember what I said at the beginning. Both plans for a self-employed individual will, on the surface, be very similar to overall benefits and negatives (if you think there are any). However, here are a few very important considerations for our self-employed individual who is desiring to establish either a self-directed SEP OR 401K and is weighing the pros and cons of each.
1) Technically speaking, the 401K (through both employer and employee contributions) can contribute up to $55,500 in total contributions whereas the SEP will be limited to a maximum of $50,000 in employer contributions;
2) Where SEP contributions can ONLY be made in a traditional, pre-tax manner, our self-employed individual can actually make traditional, pre-tax contributions, ROTH contributions or both (if the plan documents allow for such);
3) The 401K plan will allow loan provisions from the plan up to $50,000 or 50% of the account balance, whichever is less. The SEP has no loan provisions.
4) Remember, we are speaking of a self-directed plan. Therefore, as IRAs are mandated by Congress to be “held” by a custodian, our individual who elects a self-directed SEP IRA (or any other IRA) will have annual custodian fees with a self-directed IRA custodian. In contrast, it is possible to establish the 401K plan with minimal or no annual fees. This can result in our individual saving thousands of dollars in fees; and,
5) If our self-directed individual has an IRA that participates in a Prohibited Transaction (one of those IRS “no-no’s”), it is invariably a death sentence as the plan must be distributed and fully taxed and have a 10% excise tax if the event occurred prior to 59 ½. Finally, with what funds are left over that haven’t been taxed or penalized, they are no longer in an asset-protected vehicle such as the IRA.
In contrast to this, the 401K may qualify for much lesser penalties than the IRA. This is due, in part, to the plan being a qualified plan.
So, now, you have probably flip-flopped again, right? As always, this post is not intended and should not be viewed as tax, legal, financial or investment advice. But, you can see that with both plans, you can self-direct, and there are significant benefits to both. However, there may be just enough benefits to the 401K where it should be strongly considered in comparison to the SEP. Again, as mentioned at the beginning of this post, it really boils down to a personal preference and what “fits” best for your situation. I’m pretty sure BawldGuy calls it your ‘comfort zone’.
Do your due diligence and ask questions. Unfortunately, many professionals (even in the world of self-direction) urge their clients to take what they believe to be the path of perceived least resistance…the IRA. However, I think you can see that the 401K is a solid consideration for any self-employed individual….whether they are self-directing their retirement assets or not.
Next? Let’s look at the pros and cons of 401K loans and taking early distributions from your account….again, self-directed or not.
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