Switch from SEP IRA to Individual 401k

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mrbanana
Posts: 18
Joined: Thu Aug 29, 2013 10:54 am

Switch from SEP IRA to Individual 401k

Post by mrbanana »

I run a small business and am currently the only employee. I maxed out a SEP IRA just a couple weeks ago at $51k, however now I'm having second thoughts and think I should have done an Individual 401k for the year. The contribution limits would be the same for me, but I'm thinking of adding my wife as an employee so she can participate in retirement savings through the business.

So my questions are, can I somehow transfer the SEP IRA contributions to an Individual 401k? If not, is it possible for my wife to have her own SEP IRA contribution to from the business?
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southerndoc
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Re: Switch from SEP IRA to Individual 401k

Post by southerndoc »

I didn't know you could have employees with an individual 401(k).

I'm not sure if I can employ my wife to do things. I'm a physician, and I don't think paying her for doing errands would qualify.
Lafder
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Re: Switch from SEP IRA to Individual 401k

Post by Lafder »

I understand why you posted hoping for a clear answer. It is making my head hurt to read the IRS guidelines.

What I do seem to understand is that a SEP plan can be an employer and up to 100 employees. So you should be able to hire your wife and contribute in her name, if she is making a salary.

What I also have read is that a solo 401k can be for the business owner and spouse. So you should be able to add your wife there as well.

What hurts my head is the portion about highest paid employee's contribution being limited by lower paid employee's contribution. I do not fully understand this section. But it looks like it may mean your max contribution may be lowered if your wife is a much lower compensated employee. Anyone have a clear answer on this?

I am self employeed with no employees. I have had a SEP for ten years now. My accountant told me if my income goes up enough that $51,000 is less than 25% of my adjusted income, than I should incorporate and have a pension plan with higher maximum contributions.

$51,000 or 25% of adjusted, not gross income is the current max for a SEP. I was less clear on the max for a solo 401k. One thing I read said the employee max was $17,500 plus $5500 catchup if over age 50. And the employer maximum was another 4% of income? Would that hit $51k? Is that even correct?

Sorry I don't have a clear answer. I do believe you can employ and add your wife in either case. But I am concerned it may effect your maximum contributions, and negate the benefit.

I also read that if your income is over $250,000 you can not contribute to either. Is that true?

The more I read the more contradictory information I get.

Lafder
mah001
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Re: Switch from SEP IRA to Individual 401k

Post by mah001 »

Mr. B, you can get the $51k into a Individual K, but I wouldn't do it via a transfer/rollover. you're allowed to withdraw from an IRA and in effect consider it an excess contribution, even if it isn't an excess. Then adopt the individual-k, making it effective back to January 1. Then contribute the 51k tothe plan.

Southern Doc, so called individual -k does allow employees, if that employee is you or your spouse. Yes, IRS does look at people being paid a reasonable salary or wage for what work is performed.

The term individual-k is not part of official IRS verbiage. Private sector invented I-k, solo k, etc. It's just a regular 401-k plan made simpler by limiting the document's use to "highly compensated employee" parameter.

lafder, there's no 100 employee limit for a SEP. On the other hand, a SIMPLE plan can be used only when there are no more than 100 people eligible. SEP stands for simplified employee pension; confusion is understandable.

The IRS retirement plan rules regarding coverage and nondiscrimination are based on comparing the "highly compensated employees" to the "nonhighly compensated employees." By definition the spouse of the owner is a HCE, regardless of pay level. So there's no worry about needing to reduce Mr. Banana's benefit.

Don't know where you got the 4 percent. The $17,500 or $23,000 for someone age 50 is part of the $51,000 limit. If Mr. Banana's wife earns $10,000 the rest of the year, she can put 100 percent into elective deferrals (less FICA tax). But Mr. B's business can't contribute more for her over and above the 100 percent, since 100 percent of pay is one of the parameters you need to comply with.

The 250K limit on pay means you can consider only that much when doing your contribution calculation. EG if wages were 510k and you want a 51k contribution, you can't do 10 percent of 510, even if you're willing to give other employees, if any, ten percent also. You'd have to do 20.4 percent of 250 to get to the 51k.
Lafder
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Re: Switch from SEP IRA to Individual 401k

Post by Lafder »

Thank you, that helped a lot. You seem to actually understand the details!

So why would self employed folks choose a SEP vs a solo 401k?

I can see at lower incomes, a 401k may be better since you can contribute 100% of income versus a 25% of income max for SEP.

But, if you can contribute the max 51k for either, which one to choose and why?

(I got the 4% employer match from a website that acted like they knew what they were talking about. But it could have been me misunderstanding it.)

Lafder
mah001
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Re: Switch from SEP IRA to Individual 401k

Post by mah001 »

Offhand, an owners only business might choose a SEP for its lower overhead. There's no complicated plan document you must pay for, and updates to the SEP document are less frequent. With a SEP there's no Form 5500 filing. You can more easily self administer it. Depending on state law, the SEP might provide sufficient protection from creditors, tho a 401 plan is generally better on this. Taking the funds out is a straightforward matter compared to a 401 plan. You do lose the ability to borrow against the funds, but many people don't care about that.
MooreBonds
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Re: Switch from SEP IRA to Individual 401k

Post by MooreBonds »

mrbanana wrote:I run a small business and am currently the only employee. I maxed out a SEP IRA just a couple weeks ago at $51k, however now I'm having second thoughts and think I should have done an Individual 401k for the year. The contribution limits would be the same for me, but I'm thinking of adding my wife as an employee so she can participate in retirement savings through the business.

So my questions are, can I somehow transfer the SEP IRA contributions to an Individual 401k? If not, is it possible for my wife to have her own SEP IRA contribution to from the business?
One thing to keep in mind: with a SEP IRA, each employee MUST have the same percentage contributed by the employer into the account.

So, if you have $x salary and max out your y% contribution into a SEP IRA, whatever salary your wife earns from the business that year must also receive the same y% of her salary into her SEP IRA.

If you're looking to max out deductions to your retirement accounts (and you're able to put $51k away in a SEP IRA given your business income), I'd stick with that. I also have a SEP IRA for my independent contractor consulting gig, and it's a lot easier to manage, set-up and control than a solo 401k.

Just be careful of the "equal percentage contribution into each employee's SEP IRA account" requirement if your wife (or anyone else) becomes an employee.
Spirit Rider
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Re: Switch from SEP IRA to Individual 401k

Post by Spirit Rider »

There is one big advantage of an Individual 401k over a SEP IRA in your circumstances.

She could contribute a salary deferral of $17.5K ($23K >= age 50) less what she might deferring else where. Also, since your net income is well above the max compensation limit ($255K). You could allocate any amount above that (with plausible job responsibilities for your wife).

Assuming $355K total, split $255K for you and $100K for your wife. You can set the max profit sharing rate. Then your contribution would be roughly ($17.5K deferral + $33.5K profit sharing = $51K) and you wife's would be ($17.5K deferral + $20K profit sharing = $37.5K).

This gets affected differently depending on proprietorship vs. corporation. So there is some differences is actual numbers, but the premise is the same.

NOTE: I believe you could set the max profit sharing contribution rate. The fact that yours is limited, by hitting the max compensation limit and/or max contribution limit should not limit your wife's. If I am wrong, it would just limit hers to the effective profit sharing percentage you are receiving.
Spirit Rider
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Re: Switch from SEP IRA to Individual 401k

Post by Spirit Rider »

One other advantage, which may not desired by someone in the higher tax brackets, employee deferrals (not profit sharing) can be contributed post-tax to a Roth Individual 401k.

Whenever a discussion comes up about the advantages/disadvantages between a SEP IRA and an Individual 401k, it is always stated that the SEP IRA is SO much easier to setup and administer.

What exactly are these steps that are a LOT harder on an Individual 401k?
1. Yes, for setup you usually must fill out a couple of forms and mail them in vs. most SEPs where you can open online.
2. Yes, before the end of the year you must make a salary deferral designation and just keep for your records (nothing to be submitted). Every business 401k participant manages to figure this out.
3. Yes, once your account balance exceeds $250K, you must fill out and file an IRS form 5500. Your custodian will provide you the information with your other forms (1099, 5498, etc...). It is no more difficult than a form 8086, yet many on this forum have done this many times.

I'm sure anyone who is self-employed has far more difficult challenges daily than the trivial steps to setup and manage an Individual 401k to gain significant benefits.
mah001
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Re: Switch from SEP IRA to Individual 401k

Post by mah001 »

The original poster, Mr.B, never did state the amount of his compensation. If we use Spirit Rider's data, $255 for him and $100 for her, she can have a sizable contribution total too. For convenience, assume wages are w-2. Execute a Writing that states the year's profit sharing will be 25 percent. Husband defers $17,500, leaving 33,500 possible for him from profit sharing before being cut off by the $51,000 limit. Wife can defer $17,500 and get 25 percent of her 100k from profit sharing, for a total for her of $42,500. she's not limited by her husband's effective profit sharing rate, 33.5/255 equals 13 plus percent for him

By the way, it's technically possible for her to also reach 51k by giving her 33 1/2 percent profit sharing. You'd need a customized plan to do it. The 25 percent deduction limit is on a plan basis, not individual basis like a SEP. 25 percent of the $355k total allowable plan pay total is close to $90k as a theoretically possible profit sharing contribution. One point of all this is that once people are earning this kind of money, blindly choosing a plain vanilla plan may cost them more than springing for an hour with a knowledgable advisor.
Last edited by mah001 on Sun Sep 01, 2013 4:54 pm, edited 1 time in total.
Spirit Rider
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Re: Switch from SEP IRA to Individual 401k

Post by Spirit Rider »

I was just basing it on the fact that he has already hit his max compensation point. Since it is only September, by calendar days, he should be able to add an additional 50%, unless it is very seasonal.
mah001
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Joined: Fri Sep 28, 2012 9:30 am

Re: Switch from SEP IRA to Individual 401k

Post by mah001 »

It typically takes only $134,000 of salary to make $51,000 of contributions possible. That's $17,500 in deferrals plus 25 percent of $134,000 as profit sharing.
Spirit Rider
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Re: Switch from SEP IRA to Individual 401k

Post by Spirit Rider »

mah001 wrote:It typically takes only $134,000 of salary to make $51,000 of contributions possible. That's $17,500 in deferrals plus 25 percent of $134,000 as profit sharing.
Except, the OP clearly states that he maxed out a SEP IRA and not an Individual 401k.
mah001
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Re: Switch from SEP IRA to Individual 401k

Post by mah001 »

That's true. It's unlikely he has a grandfathered SARSEP, initially adopted pre 1998. So that brings us up to $204,000.
One more comment on administering your own 1 person plan. I know of thousands of people who failed at avoiding one or both of the 2 most common trouble areas. That's periodically amending your plan as needed, even if the amendment bears no relevance to the actual operation of the plan, and filing the 5500 as needed, which will be a minimum of once. Maybe my job was like a psychiatrist in that I had contact only when a problem existed. People think all they need do is properly follow the deduction rules. When the plan provider sends them a paragraph to adopt by 12/31/xx they throw it in the drawer and forget it. When they're told to file the 5500 for the year they hit $250k, they blow that too. Others make errors when filling in the blanks of their plan; don't count on the plan provider brokerage to catch the mistakes. And don't count on them to keep copies of your plan for you.
Spirit Rider
Posts: 13977
Joined: Fri Mar 02, 2007 1:39 pm

Re: Switch from SEP IRA to Individual 401k

Post by Spirit Rider »

We are getting a little off track in the weeds from the OP.

You are assuming he is incorporated, my example was sole proprietorship. The actual amount isn't important, just the fact that he has maxed out before 9/1 and about 50% more income is likely this year. My basic premise is still sound about the benefits of an Individual 401k.

The vast majority of individual 401k plans are going to be through the major providers which all have prototype plans that require no amendment action on the part of the administrators. If you have a custom plan, I'm sorry you simply have to pay attention. I'm sorry, but everyone who runs their own business should certainly be able to handle filing a form 5500 once a year when their balance exceeds $250K.

I just think this "administrative burden" of an Individual 401k is a "red herring" and shouldn't be used to discourage people from using a retirement plan that provides the most benefit to them.
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