Individual 401K vs. SEP-IRA

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Ohalawa
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Individual 401K vs. SEP-IRA

Post by Ohalawa »

I’m helping my fiancée (a physician), finishing up her training (end of June) start a retirement account. She is joining another physician (w2 or 1099, not sure yet) who does not offer a retirement plan. We have to set up one for her. I have heard that at a higher income level an individual (solo) 401K is better than a SEP-IRA, but I’m not quite sure I understand why. :?

Current plan is to set up an individual 401K with Vanguard. Is that pretty cumbersome?

Would doing so maintain her ability to contribute to a Backdoor ROTH IRA every year? Would an SEP-IRA preclude that? Any other advantages/disadvantages? What if she builds her own practice one day and has employees?

Thank you.
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tfb
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Re: Individual 401K vs. SEP-IRA

Post by tfb »

Ohalawa wrote: Thu Apr 11, 2019 11:27 am She is joining another physician (w2 or 1099, not sure yet) who does not offer a retirement plan.
Only the employer can create the plan, whether individual 401k or SEP-IRA. She should wait until it's clear whether she will be a W-2 employee or 1099.
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Ohalawa
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Re: Individual 401K vs. SEP-IRA

Post by Ohalawa »

I was under the impression that an employee can create a plan if they are self employed (i.e. 1099 with an LLC) or a W2 without a plan offered by their employer, is this not correct?
"Our life is frittered away by detail. Simplify, simplify." -Thoreau
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Earl Lemongrab
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Re: Individual 401K vs. SEP-IRA

Post by Earl Lemongrab »

Ohalawa wrote: Thu Apr 11, 2019 3:12 pm I was under the impression that an employee can create a plan if they are self employed (i.e. 1099 with an LLC) or a W2 without a plan offered by their employer, is this not correct?
The first part is, the second is not. As noted, only the employer can set up the plan. For a self-employed situation, you act as both employer and employee.
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Artful Dodger
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Re: Individual 401K vs. SEP-IRA

Post by Artful Dodger »

Ohalawa wrote: Thu Apr 11, 2019 3:12 pm I was under the impression that an employee can create a plan if they are self employed (i.e. 1099 with an LLC) or a W2 without a plan offered by their employer, is this not correct?
If she is a 1099 independent contractor, she can set up either a self-employed 401k or SEP IRA. The contribution limit is the same - $56,000. The 401k allows her to make a deferral up to $19K from her salary (that she would pay herself from her business) and contribute 25% of her pay as an employer contribution. The SEP IRA allows no employee contribution, and the employer (her) can contribute up to 25% of her compensation. The 401k will allow a higher overall contribution when her salary is lower. Ie. Pays herself $148k, makes a salary $19k deferral, and contributes 25% of pay or $36k, $55k total. The SEP IRA route would require $224k in compensation to make a similar $56k contribution.

There are other pros and cons which are more business decisions. Ie, if she is an S-Corp, she may be paying herself a lower salary to reduce some FICA or medicare taxes, and then the 401k would allow the greater contribution. The SEP IRA is simpler, and won't have some of the reporting requirements of the 401k, like an annual 5500 form filing when her plan assets exceed $250k.

If she is actually an employee, and her employer is paying her a salary, she would be limited to a traditional or ROTH IRA with a maximum contribution of $6000. She also loses the full tax deduction when income exceeds $137k single / $203 joint filing. She can contribute after tax to a ROTH IRA with income up to $137k single / $203 joint filing.
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Ohalawa
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Re: Individual 401K vs. SEP-IRA

Post by Ohalawa »

Wow, super helpful, thank you! :happy
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Greenman72
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Re: Individual 401K vs. SEP-IRA

Post by Greenman72 »

If you get a 1099, go SEP.
If you get a W-2, go traditional IRA.
Spirit Rider
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Re: Individual 401K vs. SEP-IRA

Post by Spirit Rider »

If she wants to be able to do Backdoor Roths, she does not want to use a SEP IRA. She should adopt a one-participant 401k. You actually have it backwards, one can maximize the annual additional limit (2019 = $56K) on a lower income with a one-participant 401k than with a SEP IRA.

If she may one day add employee(s), she should not adopt a Vanguard Individual 401k. Vanguard does not allow employee eligibility restrictions. All of the other mainstream low cost brokerages offer one-participant 401k plans with employee eligibility restrictions. This would allow her to maintain the one-participant plan until she has eligible employees >= age 21 and after one year of >= 1,000 hours/year of service.
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Re: Individual 401K vs. SEP-IRA

Post by Greenman72 »

Spirit Rider wrote: Thu Apr 11, 2019 11:42 pm If she wants to be able to do Backdoor Roths, she does not want to use a SEP IRA. She should adopt a one-participant 401k.
I don't understand this part of your post. Can you explain, please?
fraser
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Re: Individual 401K vs. SEP-IRA

Post by fraser »

If you are an entrepreneur, don't forget you can hire your spouse and take the same 56k deduction (assuming enough income). And also remember to look at a section 105 health reimbursement plan which can allow you to take all of your insurance payments, copays, and all medical expenses pre-tax.
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Re: Individual 401K vs. SEP-IRA

Post by Spirit Rider »

Greenman72 wrote: Fri Apr 12, 2019 10:03 am
Spirit Rider wrote: Thu Apr 11, 2019 11:42 pm If she wants to be able to do Backdoor Roths, she does not want to use a SEP IRA. She should adopt a one-participant 401k.
I don't understand this part of your post. Can you explain, please?
Roth conversions are subject to pro-rata taxation of the non-deductible basis and all pre-tax balances in all traditional, SEP and SIMPLE IRA accounts.

The goal of a Backdoor Roth is to do the Roth conversion portion with little to no tax liability. Using a SEP IRA would result in the majority of any conversion being taxable income
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Re: Individual 401K vs. SEP-IRA

Post by Spirit Rider »

fraser wrote: Fri Apr 12, 2019 10:28 am If you are an entrepreneur, don't forget you can hire your spouse and take the same 56k deduction (assuming enough income). And also remember to look at a section 105 health reimbursement plan which can allow you to take all of your insurance payments, copays, and all medical expenses pre-tax.
Easier said than done and not nearly as useful as you propose.
  • A business owner can't just "hire" their spouse. They must perform business "necessary" tasks and be paid a fair market value FMV wage for the "actual" number of hours worked. Pretty hard for the OP's physician fiance being paid just for services to require a large number of hours of business necessary tasks at a justified high FMV wage.
  • Pass-thru business owners can not cover themselves with a Section 105H medical reimbursement plan. They would have to be able to justify hiring a spouse as above and the spouse would have to cover the business owner under a family plan. Oh, and the total compensation for the spouse would include the medical reimbursements and would have to be justified as above.
  • Don't forget that the spouse's wages would be subject to the full FICA of 15.3%, where the business owner's earned income > the SS maximum wage base would only be subject to 2.9% SE tax.
  • The additional spousal wages and employer retirement plan contributions would reduce qualified business income QBI and the QBI deduction if eleigible.
  • Etc...
aristotelian
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Re: Individual 401K vs. SEP-IRA

Post by aristotelian »

At high income, 401k is advantageous for the reason Spirit Rider said--SEP would interfere with Backdoor Roth.
At lower income, 401k is advantageous because you can contribute more due to the $18K individual contribution.
Basically, you should almost always do Solo 401k.
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Re: Individual 401K vs. SEP-IRA

Post by Spirit Rider »

aristotelian wrote: Fri Apr 12, 2019 11:04 am At high income, 401k is advantageous for the reason Spirit Rider said--SEP would interfere with Backdoor Roth.
At lower income, 401k is advantageous because you can contribute more due to the $18K individual contribution.
Basically, you should almost always do Solo 401k.
I can only think of a couple reasons to do a SEP IRA vs. a one-participant 401k
  • The deadline for adopting a one-participant 401k for 2018 contributions was 12/31/18. You have until 4/15/19 (MA/ME 4/17/19) including extensions 10/15/19 to open and fund a SEP IRA for 2018. If you haven't done so by now, you should file an extension now. It prevents some last minute glitch from preventing the contribution.
  • You don't need to use the Backdoor Roth and you are already maximizing the employee elective contribution limit elsewhere.
  • You can always adopt a one-participant 401k later even if you don't have self-employed earned income that year and rollover the SEP IRA.
Greenman72
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Re: Individual 401K vs. SEP-IRA

Post by Greenman72 »

fraser wrote: Fri Apr 12, 2019 10:28 am If you are an entrepreneur, don't forget you can hire your spouse and take the same 56k deduction (assuming enough income). And also remember to look at a section 105 health reimbursement plan which can allow you to take all of your insurance payments, copays, and all medical expenses pre-tax.
Good idea. Hire your spouse and pay them $275,000. Pay $25,000 in payroll tax expense. Save $15,000 in income tax!!! Net cost to hire spouse = $10,000.
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Re: Individual 401K vs. SEP-IRA

Post by Greenman72 »

Spirit Rider wrote: Fri Apr 12, 2019 11:31 am I can only think of a couple reasons to do a SEP IRA vs. a one-participant 401k
  • You can always adopt a one-participant 401k later even if you don't have self-employed earned income that year and rollover the SEP IRA.
If this is true, then why not opt for the (much easier) SEP, then when you're ready to do the Roth conversion, roll all the funds that you don't want to convert into the 401k at that time?
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Re: Individual 401K vs. SEP-IRA

Post by Spirit Rider »

Greenman72 wrote: Fri Apr 12, 2019 12:30 pm
Spirit Rider wrote: Fri Apr 12, 2019 11:31 am I can only think of a couple reasons to do a SEP IRA vs. a one-participant 401k
  • You can always adopt a one-participant 401k later even if you don't have self-employed earned income that year and rollover the SEP IRA.
If this is true, then why not opt for the (much easier) SEP, then when you're ready to do the Roth conversion, roll all the funds that you don't want to convert into the 401k at that time?
That is fine if you are talking about years, but it doesn't make sense if it is a matter of months. IRS regulations prohibit maintaining a 5305-SEP IRA for any tax year you maintain a qualified plan (one-participant 401k).
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Re: Individual 401K vs. SEP-IRA

Post by aristotelian »

Greenman72 wrote: Fri Apr 12, 2019 12:30 pm
Spirit Rider wrote: Fri Apr 12, 2019 11:31 am I can only think of a couple reasons to do a SEP IRA vs. a one-participant 401k
  • You can always adopt a one-participant 401k later even if you don't have self-employed earned income that year and rollover the SEP IRA.
If this is true, then why not opt for the (much easier) SEP, then when you're ready to do the Roth conversion, roll all the funds that you don't want to convert into the 401k at that time?
How is SEP "much easier"? I have done both and noticed no difference, other than the tax form once you hit $250K.
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Earl Lemongrab
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Re: Individual 401K vs. SEP-IRA

Post by Earl Lemongrab »

aristotelian wrote: Fri Apr 12, 2019 1:06 pm
Greenman72 wrote: Fri Apr 12, 2019 12:30 pm
Spirit Rider wrote: Fri Apr 12, 2019 11:31 am I can only think of a couple reasons to do a SEP IRA vs. a one-participant 401k
  • You can always adopt a one-participant 401k later even if you don't have self-employed earned income that year and rollover the SEP IRA.
If this is true, then why not opt for the (much easier) SEP, then when you're ready to do the Roth conversion, roll all the funds that you don't want to convert into the 401k at that time?
How is SEP "much easier"? I have done both and noticed no difference, other than the tax form once you hit $250K.
More importantly, if things change and you need an i401(k), you already have one.
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