Small Business Financial Article

The Advantages of a 401k over a SEP or SIMPLE for Business Owners

The Advantages of a 401k over a SEP or SIMPLE for Business Owners

For business owners, there’s no shortage of retirement plan options, each with the capacity to accept larger contributions than individual or employee plans with commensurate tax advantages. Until recently, the default options for many business owners had been the Simplified Employee Pension (SEP IRA) or the Savings Incentive Match Plan for Employees (SIMPLE IRA) chosen in large part for their low cost and simplicity. However, for business owners in the right situation, the 401k plan is quickly becoming the plan of choice for its even greater capacity and flexibility.

In small business vernacular, the 401k plan is known by such names as "solo 401k," "individual 401k," or "SBO-401k. Like its larger version, the solo 401k does entail reporting and administration provided by a third party administrator; but, for business owners, that where the similarities end. And, if the prospect of paying the higher costs associated with plan administration had been a dissuasive factor, their gain in popularity is your gain due to the increased competition among providers offering 401k plan services. So, setting the cost factor aside, what should you, as a business owner, know about the 401k plan and its advantages over other options?

Making the Comparison

First, in order to compare the individual 401k plan with other options, it must be done in the right context - and that is a situation in which the business owner is the sole, eligible employee (along with a spouse). A business owner with employees can still be eligible for an individual 401k, as long as they are part-time (less than 1000 hours). With part-time employees it’s important to monitor their hours to avoid unintended plan eligibility should they exceed 1000 hours.

For sole proprietors, or single-employee business owners operating as a C-Corp, S-Corp or LLC, the comparison of the three options is fairly straightforward, and aside from the reporting requirements of the 401k plan, it comes down to the contribution limits.

Business Owner Retirement Plan Comparison

Who can contribute Employee; employer optional Employee & Employer Employer only; must make uniform contributions on behalf of all eligible employees
Maximum employee contribution $22,500 plus $7,500 catch up if over 50 $12,500 plus $3,000 catch up if over 50 NA
Employer contribution Up to 25% of earnings capped at $66k ($73.5K if over 50) including profit sharing option Must match 100% of first 3% of participating employee contributions or 2% of all eligible employee salaries Employer-only contribution up to 25% of income or compensation with a $53K cap
Access to funds before 59½ Participant may take penalty-free loans; 10% penalty for early withdrawal 25% penalty for withdrawals within first two years of plan; 10% thereafter 10% penalty for early withdrawal
Vesting Can have vested schedules that are long as 6 years on employer contributions Participants are 100% Vested on all contributions Participants are 100% Vested on all contributions

To illustrate, Sally, age 51, is taxed as a corporation with W-2 wages of $70,000. Looking for a plan that allows the highest contribution limit, she compares the options:

Plan Option Employee Salary Deferral Employer Contribution Total Contribution
Indv. 401k $10,500 $17,500 $38,000
SEP IRA $0 $17,500 $17,500
SIMPLE $19,000 $2,100 $21,100

The biggest advantage, as shown here, is that the individual 401k plan allows for both an employee and employer contribution. In addition, Sally would enjoy the following key advantages:

  • If her spouse, Sam, age 49 is employed at the company and had W-2 wages of $40,000, they can add his salary deferral up to $18,000 and make a profit-sharing contribution of $10,000 putting a combined total at $64,000 in the plan.
  • If he chose to do so, he could employ the Roth 401k option, which has no income restrictions, for his salary deferral contribution. His contribution would not be pre-tax, but he would be able to withdraw funds tax free.

Finally, the employer has flexibility to design, modify, or even terminate a 401k plan. Unlike a SEP IRA or SIMPLE IRA, which use fixed, standard contribution formulas and eligibility requirements, a 401k plan sponsor can adjust contribution formulas and eligibility requirements to suit their particular needs or profit situation. In addition, SEPs and SIMPLEs can only be terminated at the end of the calendar year, whereas a 401k plan can be terminated at any time. 401k plans afford additional benefits for employers who seek the greatest amount of flexibility in their retirement plan.

For self-employed business owners, the 401k plan offers the highest contribution limits, much more flexibility in designing their plan for optimal tax advantages. The added benefit of penalty-free access via loans in the event of the unexpected provides even greater flexibility over the other plan types.

As always, it is strongly recommended that you consult with a qualified plan expert to thoroughly assess your needs and circumstances when selecting a retirement plan for your business, especially if you anticipate hiring new employees.

Read other small business financial articles