Individual 401(k)s May Offer Self-Employed More Advantages Than a SEP IRA

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Both the Simplified Employee Pension (SEP) IRA and the Individual 401(k) offer great retirement options for the self-employed. But when compared side-by-side, the Individual 401(k) comes out ahead as it offers more and better options for solo workers looking to accelerate levels of contributions while reducing annual taxes.

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At first blush, both plans have very high 2011 savings limits of $49,000. However, if you’re 50 years of age or older, the 401(k) allows for a $5,500 catch-up to save $54,500 a year – something a SEP IRA doesn’t.

And while the SEP IRA can be a little less expensive to manage, the solo 401(k) offers greater flexibility in managing taxes, provides access to savings penalty-free in case of emergency, and enables the self-employed to max-out his savings faster. In fact, the Individual 401(k) can both help you save more for retirement with less income than a SEP can and also help shelter more from taxes including the potential for a significantly lower adjusted tax rate and bracket.

How They Compare Side-by-Side

Here’s a chart that compares each plan side-by-side:

2011

SEP IRA

Individual 401(k)

Savings Limit if Under 50

$49,000

$49,000

Savings Limit if Over 50

$49,000

$54,500 due to the $5,500

401(k) Catch up Provision

Penalty-Free Loan Option

No

Yes; half of balance up to $50K

Roth 401(k) Option

No

Yes, $16,500 limit if <50; $22,000 if over 50

Tax Deadline

Typically 4/15

Typically 4/15 for profit Sharing but 12/31 for “employee contributions”

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Max-Out Savings Significantly Faster with a 401(k)

A SEP IRA enables a self-employed business to put 25 percent of W-2 earnings or 20% of net self-employment income into the plan. The same is true for a 401(k) with a significant wrinkle that can help maximize personal savings faster. Here’s why: In an individual 401(k) the plan holder is considered both an employee and employer. As an employee the plan holder can contribute 100% of compensation into his 401(k) up to $16,500 if under 50 years of age, or $22,000 if 50 or over. The self-employed can then profit share the 25 percent of W-2 or 20% of net self-employment income.

Here’s an example to show you how it works with the following assumptions:

No. 1: As most self-employed businesses are sole proprietorships or 1099s, let’s use 20% of net self-employment income as the basis for the comparison

No. 2: Let’s also assume the self-employed person is under 50 years of age.

No. 3: The 401(k) owne r is providing all contributions tax-deferred (not using the Roth option).

Sole Proprietor Under 50 Years of Age

SEP IRA

401K

Earnings Needs to Max Savings

$245,000

$162,500

Employee Contribution

NA

$16,500

20% of Net Self-Employment Contribution

$49,000

$32,500

 

 

 

Total Savings

$49,000

$49,000

 

 

 

Taxable Income

$196,000

$113,500

In this example, the self-employed worker can earn $82,000 less with a 401(k) to hit the $49,000 savings limit. This can save the 401(k) holder a lot more in taxes for the current calendar year on both the income that the IRS will tax and keeps the owner in a lower tax bracket, so an overall lower tax rate is achieved for the calendar year.

While both the SEP IRA and the Solo 401(k) offer great retirement and tax-saving benefits to the self-employed, the 401(k) may be a better option for many that are seeking a faster path to maxing-out contributions by leveraging the status of both employer and employee.

Stuart Robertson is general manager and principal of ShareBuilder Advisors, LLC which operates www.ShareBuilder401k.com. ShareBuilder Advisors, LLC is a subsidiary of ING Bank, fsb.

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