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SEP IRAs vs. 401(k)s: Which Is Right for Your Small Business?

SEP IRAs vs. 401(k)s for Small Businesses
Self-employed or small business owner seeking an alternative to the 401(k)? A SEP IRA may be right for you. In this post, we discuss the differences between SEP IRAs vs. 401(k)s.

In this post, we’ll be looking at SEP IRAs vs. 401(k)s to help you decide which is best for you and your employees. Choosing the right small business retirement plan can be overwhelming. There are many factors to consider—contribution limits, tax implications, employee matching requirements—the list goes on. 

While a 401(k) is the most common employer-sponsored retirement plan, it’s not always the best fit. Fortunately, there are other retirement plans for small business owners and self-employed individuals to consider, like a SEP IRA.

Why It’s Important for Small Business Owners to Offer a Retirement Plan

To understand the conversation around SEP IRAs vs. 401(k)s, we must first establish the importance of offering a retirement plan as part of a well-rounded recruitment and retainment process.

The pandemic undoubtedly disturbed business operations for small business owners and self-employed individuals. However, a new analysis found that self-employment is back to the level it was pre-pandemic. With many employers struggling to recruit and retain employees due to the “Great Resignation,” it’s more vital than ever, particularly for small businesses, to ensure their employees are satisfied. 

Certainly, this includes competitive compensation and benefits packages that set your employees up for a healthy financial future. Offering a retirement plan can be a powerful tool that discourages turnover and encourages loyalty

What Is a SEP IRA? 

Often overshadowed by the more well-known 401(k), a simplified employee pension IRA is a type of retirement plan for self-employed people and small business owners. Employers can set aside money into SEP IRAs for themselves and their employees. 

A SEP IRA is an employer-sponsored plan, and contributions come directly from an employer. However, a SEP IRA owner can make traditional IRA contributions directly to their account up to the applicable limit. An additional benefit is that SEP IRA contributions are 100% vested on day 1, which makes them a strong tool to attract and retain employees.

Further, a SEP IRA is a traditional IRA and follows the same investment, distribution, and rollover rules as traditional accounts. Importantly, SEP contributions are tax-deferred, meaning federal income taxes are paid at withdrawal instead of at contribution. There is an option to convert your SEP IRA to a Roth so taxes are paid upfront, but the choice to do so should be based on each individual’s desired retirement mix.

Those who are self-employed can contribute in the capacity of an employer. Keep in mind that if you do open a SEP IRA for your business, the percentage contributed must be the same across all employees, including yourself.

5 Benefits of a SEP IRA vs. 401(k) for Your Small Business

There are pros and cons to each retirement plan, and no option is perfect. But for many small businesses, SEP IRAs may be a better fit due to their simplicity and flexibility. Here are five benefits of  SEP IRAs vs. 401(k)s:

1. SEP IRAs Have a Higher Contribution Limit vs. 401(k)s

The contribution limits for SEP IRAs are currently more than double that of 401(k) accounts, making SEP IRAs a better option for small business owners who want to direct more money into retirement investments. For a SEP IRA, an employer contribution cannot exceed the lesser of 25% of the employee’s compensation or $61,000.

Although SEP IRAs don’t offer “catch-up contributions” like 401(k)s, the contribution limit is already much higher than that of a 401(k). For 2022, the 401(k) contribution limit is $20,500 ($27,000 for those 50 and older). Since an employer’s obligation to contribute to a 401(k) is only equal to the percentage match offered, a SEP IRA has the potential to greatly benefit an employee, regardless of its lack of “catch-up contributions.”

Further, with a SEP IRA, you can also make contributions up until the tax filing deadline, plus extensions, for the previous year while the cutoff for 401(k) contributions is December 31 of a given year. 

2. SEP IRAs Are More Flexible Than 401(k)s

SEP IRAs allow employers greater freedom when it comes to contributing money to the plan. Employers can choose when and how much they want to contribute—whether in multiple contributions or one large contribution during the year. 

This flexibility makes a SEP IRA an ideal retirement plan for small businesses with fluctuating profits over the course of the year or from one year to the next. Because you can contribute flexibly, you can contribute more, less, or defer depending on your company’s financial circumstances.

3. SEP IRAs Don’t Require Annual Filings or Paperwork to Maintain

“Simplified” is part of the name for a reason. Unlike 401(k)s, which are subject to rigorous reporting requirements, SEP IRAs are much easier to set up and maintain. Since SEP IRAs don’t require annual filings or paperwork to maintain, small business owners can bypass the monetary risk associated with accidental failure to comply with ERISA rules. This makes them a great choice for business owners who don’t have the time or resources to manage annual filings. 

In fact, in a recent interview with Forbes Advisor, Ted Benna, the so-called “Father of the 401(k)” discussed the 401(k) plan’s shortcomings, one of which being the administrative headaches. He admitted that for many small businesses, a simpler solution may be a better fit.

4. SEP IRAs Provide Employers Tax Advantages

One of the major benefits of using a SEP IRA is tax advantages. Contributions made to a SEP IRA are fully tax-deductible, giving employers and self-employed individuals a dollar-for-dollar reduction in taxable income. For entrepreneurs who worry about their end-of-year tax bill, this deduction can make a difference. And for small business owners, the tax-advantaged savings allow them to be generous with employees. 

5. SEP IRAs Often Provide More Investment Options

When Congress passed the Pension Protection Act of 2006, employers were given legal protection if they automatically enrolled their employees in a 401(k) with a target-date fund. Now, target-date funds hold 24% of all assets in 401(k) plans, which is more than any other asset. 

Though this legislation was intended to protect workers, it inadvertently caused retirement investing to become something employees put on autopilot. In contrast, a SEP IRA often provides more investment options. Why is this important? Because diversification makes one asset’s performance less likely to affect your entire portfolio. 

And there’s a lot more you can invest your SEP IRA into than most custodians allow—think startups and pre-IPO companies, cryptocurrency, real estate, farmland, and even securitized fine art. Investing in alternative assets you’re interested in can help diversify your portfolio and create the potential for outsized returns. 

How to Claim a $5,000 Tax Credit Toward a SEP IRA for Your Small Business

While many small business owners may be hesitant to provide retirement options for their employees due to the perceived high cost, now may be a great time to start due to a newly expanded tax credit for eligible employers. The credit, worth up to $5,000 for three years, goes toward the cost of starting a SEP, SIMPLE IRA, or 401(k) plan for employees as part of the SECURE Act. Employers qualify for this credit if:

  • They had 100 or fewer employees who received at least $5,000 in compensation during the previous year.
  • At least one plan participant they employed was a non-highly compensated employee.
  • Their employees did not receive contributions or benefits from another plan sponsored by them in the last three tax years. 

If eligible, you can claim the credit by filling out and submitting this IRS form.

Use Your SEP IRA to Invest In Opportunities You’re Interested In

Undoubtedly, as a small business owner, you understand the value of doing your due diligence to plan for the future. Similarly, this skill is vital when deciding whether a SEP IRA vs. 401(k) retirement plan is right for your small business. 

With Alto, you can use SEP IRA funds to invest in alternatives that have low to no correlations with public markets and the potential for outsized returns. Alto offers two ways to invest tax-advantaged funds in alternatives: 

  • Alto IRA lets you invest your IRA funds into alternative assets with 75+ partners—such as startups, securitized art, real estate, private equity, and more.
  • CryptoIRA makes it easy to invest in more than 135 crypto coins and tokens.

Whichever you choose, approaching your retirement goals with the same grit as you approach your business will serve you well. 

To set up a SEP IRA with Alto, create an account today or request a call from our Investor Success team to talk over how to set up a SEP IRA for your business.