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

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.

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:

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).

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.

Be Confident in Higher SEP IRA Maximum Limits | Pueblo Real Estate ...

The SEP IRA maximum contribution is far more generous than the contribution limit allowed with otherforms of traditional individual retirement accounts. A SEP plan isappropriate for the self-employed person , and for small companies that might not have the ability to supply their employees with a more conventional retirementplan. SEP, or Simplified Employee Pension Plans, aresimple to establish and low cost to administer. Thelargest advantage could well be the higher SEP IRA maximum contribution associated with these accounts . For the self-employed, the SEP IRA maximum contribution is calculated on net profits from the business enterprise, up to 20% or $44,000 per year . The contribution amount is calculated by taking the net self-employment income and subtracting one half of the self-employment taxes, then multiplying that net/net income by 20%. For small business plans, the qualified employees could contribute up to $49,000 per year, or 25% of their annual salary , whichever is less. The employer decides the amount and frequency of contribution, and can review annually to change or even do away with the contribution. It is the employer who makes the contribution on the employee’s behalf. Often businesses choose a mutual fund company to administer the account , making it possible for each individual participating in the plan to decide on their own investments based on their goals and investment philosophy. Eligible employees must be 21 years old , and have worked for the company for three of the past five years, receiving a minimum $550 in compensation for their work. With these higher SEP IRA maximum contribution limits, it isachievable for people participating in the plan to quickly accrue a greater amount of savings toward their retirement. The money iscompletely vested as soon as it is contributed, so the account can be rolled over into another IRA, or in the case of an employment change can be transferred to another employer’s qualified retirement plan. Higher SEP IRA maximum contributions are a benefit worth exploring .

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