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401(k)s, Solo 401(k)s, and SEP IRAs: What’s the Difference?

Gusto Editors  
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Do you know the difference between solo 401(k)s and SEP IRAs?

Since the future comes with many unknowns, we need to prepare for the future regardless of what it brings. Retirement investment is necessary to have security for the future, but various investment opportunities make it hard to choose the right plan. If you want to learn more about the difference between retirement plan offerings and how to help your small business clients choose the right option for their employees, this article series is for you. 

We at Gusto are happy to have partnered with CPA Academy to present an informative article series about retirement plan options for you and your clients. The webinar “401(k) or SEP IRA” took an in-depth look at different types of retirement investment opportunities and which types are the right fit for your clients under the guidance of Nicolle Willson.

Nicolle Willson is the retirement consulting director at Guideline, a 401(k) and retirement solution for small business owners. If you are currently looking for a retirement option to offer your clients, Guideline’s platform provides easy-to-use retirement investment options and seamlessly integrates with the Gusto payroll platform. 

In this article, we will look at the structural distinctions and variations in features of 401(k) vs. SEP IRA and how to set up an SEP IRA–and there is a lot of information to cover.

Solo 401(k) vs. SEP IRA structural distinctions

When looking at 401(k) vs. SEP IRA plans, one of the most significant differences is in who can contribute to the account. Employees with 401(k) accounts can actively participate in their retirement investment, either by choosing designated amounts of funds to deposit into the account or having a percentage taken from their paychecks. Conversely, employers are the only party able to contribute to an SEP IRA.

“An SEP IRA is a Simplified Employee Pension plan. Any sized business can set it up, allowing employers to contribute to IRA accounts for their employees. It does not allow employees to contribute via payroll deduction to their own accounts. “

– Nicolle Willson
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In addition to having differences between contributions, SEP IRA eligibility requirements vary from 401(k) eligibility. SEP accounts have higher maximum restrictions than the eligibility requirements of a 401(k):

“Eligibility requirements for SEP are different from 401(k). The maximum eligibility requirements for an SEP are that you have to be at least 21 years old, you have worked for the employer three of the past five years, and you need to have earned at least $650 during the year.”

– Nicolle Willson

401(k) investment plans set the same age limit at 21, but 401(k) plans also give employers some flexibility when setting eligibility requirements. One key difference is that employees are only required to be working at the business one year before they can start making deferrals into their accounts.

Another variation between SEP IRAs and 401(k)s is their vesting schedules. SEPs will always provide immediate vesting to employees of all contributions, while 401(k) allows the employer the ability to choose a vesting schedule for investments.

The final significant difference between 401(k)s and SEP IRAs is that SEP IRAs are not fully covered by ERISA because they are IRA-based investment plans. The partial coverage of ERISA keeps their investors from having the complete bankruptcy and creditor protection that 401(k)s do. However, there are benefits to the limited ERISA coverage:

“The good news here is that SEP IRAs are exempt from most ERISA requirements, including any fiduciary responsibility of managing funds after they hit the employee IRA accounts. Since the plan is IRA-based, the employee is going to be in charge of their own investing. Plans are also generally exempt from the government filing requirements. … They are exempt from fee disclosure requirements since the employer does not handle the investments. Finally, they are exempt from nondiscrimination testing as the contributions are made with a pre-approved formula.”

– Nicolle Willson

SEP IRAs and 401(k)s have one intrinsic similarity—tax savings and credits:

“Employers are going to get the same tax credit for a new SEP plan as they would for setting up a new 401(k). … Employer contributions also have the same tax advantages as a 401(k). The one difference is the total account deposit. With an SEP IRA, the maximum you can deposit to an individual’s account is less than 25% of their compensation or $58,000 annually. With a 401(k) that 25% limit is assessed at the plan level for all eligible compensation, and it is just a deductibility limit instead of a maximum deposit limit.”

– Nicolle Willson

Tax savings aside, the structure of these investment plans offers more differences than similarities. Their differences allow employers to determine which qualifications and investment strategies work best for their business. 401(k) plans and SEP plans also offer variations in features for employees beyond how they are structured. 

401(k) vs. SEP IRA feature variations

One major difference in features between 401(k) and SEP plans is how investments happen with their plans. When investing with 401(k) accounts, the business assumes all investment responsibility. On the other hand, with the SEP, the employee is responsible for choosing their investment opportunities.

Business owners sitting together looking at expenses and bills

Another key feature that differs SEP IRAs from 401(k) is how employees can withdraw funds:

“In terms of easy withdrawal, SEPs are better vehicles as they allow an individual to withdraw their funds at any time, whereas the 401(k) is only going to allow withdrawals before normal retirement age in very specific circumstances: hardship, disability, death, etc.”

– Nicolle Willson

In addition to funds withdrawal, the two investment plans offer different restrictions when looking at loans. 401(k) plans allow you to take out loans on the balance of your investment, while SEP IRAs prevent you from borrowing against them.

“401(k) plans allow for loans, while SEPs cannot. Some people do find [401(k)s] a better way to make use of their retirement funds since they can pay that money back and still have it for retirement eventually.”

– Nicolle Willson

Be sure to consider all of the differences between 401(k)s and SEP IRAs before dedicating to a single choice for your business. The size, age of employees, and time you have to invest into the retirement accounts all serve as factors when deciding between the options. 

Setting up SEP IRA accounts

The setup of a simplified employee pension plan needs considerably fewer steps than setting up a 401(k). The more straightforward process makes it possible for businesses to have a relatively hassle-free way to establish retirement options for employees.

“Setting up an SEP is fairly simple. First, you need to execute a written agreement. Many SEPs use the IRS model SEP plan document. This form is called Form 5305-SEP. It’s super easy to fill out. Two checkboxes, and that’s it. After that, you will need to notify your eligible employees and give them certain information about the SEP. The easiest way to do that is to provide Form 5305-SEP as well as Form 5498, but you can also provide notice in any other format.”

– Nicolle Willson

After providing notice to employees, the next step is to set up an SEP IRA account for each employee by the income tax return deadline for that year. Once the accounts are created, your employees are ready to invest in their retirement accounts.

SEP administration and reporting win out over 401(k) because of the simplicity:

“In terms of SEP administration and reporting, it’s quite a bit easier than maintaining a 401(k). … Annual administration consists of doing a one-time calculation for you and your employees as well as sending an annual statement. Throughout the year, you don’t have to worry too much about the plan. There is no compliance testing, there is no investment management, and there is no 5500 filing.”

– Nicolle Willson

The overall design of SEPs provides a simplified retirement option for employers to offer their workers. If you need an opportunity for your employees to invest in their future but do not have the time to dedicate to a 401(k) plan, the SEP IRA may be the right fit for you.

Learn more about different retirement investment opportunities for small business owners

One outlying retirement plan for small businesses is the solo 401(k) or solo-k. These plans specifically apply to single-owner companies with no employees:

“Defined by the IRS, a solo 401(k) is simply a one-participant 401(k) plan that covers only a business owner and potentially their spouse, and the business has no other employees to cover. In short, it’s a 401(k) plan for owner-only businesses. It’s important to note that the IRS states that this is not a new type of 401(k) plan. It is a traditional 401(k) plan that has the same rules and requirements as any other 401(k) plan.”

– Nicolle Willson

If you would like to learn more about retirement plan options for small businesses, you can watch the entire webinar here. Also, be sure to look out for Part One and Part Three of this article series to find out more about 401(k) plans and which are best for your small business clients.

Our mission at Gusto is to help accountants and their clients gain peace of mind on their financial journey. We currently partner with over 4,500 firms nationwide to promote security and cultivate a positive work environment. Be sure to look into our People Advisory Program to learn how to connect with your clients beyond their finances. We also provide a partner blog full of resources for all your advising needs. Visit our Gusto for Accountants page for more information on utilizing people-based accounting within your firm.

Updated: April 4, 2022

Gusto Editors
Gusto Editors

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