Last Updated: December 19, 2023
As a small business owner, carving out a reliable path to retirement for yourself and your employees is an important part of your financial plan. When thinking about the retirement plan options available, two common choices to consider are SEP plans and 401(k) plans.
SEP plans, short for Simplified Employee Pension plans, are often used by small business owners and self-employed individuals due to their straightforward nature. 401(k) plans, on the other hand, are perhaps the most popular option because of their flexibility and wider range of features.
In this article, we’ll explore the key differences between SEP plans and 401(k) plans. You’ll gain the insights you need to build a retirement benefits package that sets you up for long-term success.
A SEP plan is a tax-advantaged retirement savings plan that can be established by any employer, including those who are self-employed. It allows employers to make company contributions towards their own and their employees' simplified employee pension individual retirement accounts (SEP IRAs).
A 401(k) plan is also a tax-advantaged, employer-sponsored retirement savings plan. Any size business can offer a 401(k) plan to help their employees save for retirement. Employees can choose to defer a portion of their salary into the plan, and often, employers will match a percentage of those contributions. This type of plan is widely adopted across various industries and business sizes.
Now that you know the basics, let's see how these two types of retirement plans differ when it comes to contributions, eligibility, vesting, and loans.
SEP plans do not allow for employee contributions. Only employers can contribute to SEP IRAs.
With most SEP plans, employers must contribute an equal percentage of their compensation for all eligible employees (up to the IRS limit). The decision about what percentage to contribute each year can vary. Contributions aren't required every year, but when they are made, they must include all employees who worked during that year, even if they no longer work for you.
Employers can choose to make these contributions on a pre-tax basis, meaning your money will not be taxed until it is withdrawn, or an after-tax (Roth) basis, meaning withdrawals will be tax-free.
In 2024, employers can make contributions equivalent to up to 25% of each employee's salary or $69,000, whichever is lower. A maximum of $334,000 of an employee's earnings can be taken into account for determining contributions. If you're self-employed, you can use this page to determine your contribution limit.
In a 401(k) retirement plan, both employers and employees have the opportunity to make contributions. Employees decide how much of their salary they want to contribute, within federal limits, and this amount is deducted from their paychecks. Employees can choose to make these contributions on a pre-tax basis or Roth basis.
On top of this, many employers offer a matching contribution, where they contribute additional funds based on a percentage of what the employee contributes. For instance, an employer might offer a 50% match up to 6% of the employee's salary. The chart below shows what this match would look like for an employee making $50,000:
Some employers might also offer a non-elective contribution, which is a set contribution regardless of the amount the employee contributes.
With a 401(k), the employee contribution limit is $23,000 for 2024, with an additional catch-up contribution of $7,500 for those 50 and older. The total contribution limit (including both employer and employee contributions) is $69,000.
Employees must be eligible to participate in a SEP plan if they have:
Keep in mind that every eligible employee will receive the employer contribution.
With a 401(k) plan, employers have greater flexibility in setting eligibility criteria. For example, employers can choose to exclude certain types of employees from a 401(k) plan, which is generally not permissible in a SEP plan.
Generally, an employee must be allowed to participate in a 401(k) plan if they are 21 years of age or older and have completed a year of service with the company (defined as 1,000 hours of service over 12 months). In addition, there are new requirements for long-term part-time employees which take effect January 1, 2024, that create specific eligibility requirements for part-time employees for deferral purposes only. This means that part-time employees who do not meet the overall eligibility for plan participation may be eligible to defer into the plan, but not for employer contributions.
All contributions made to SEP accounts are always 100% vested, meaning that employees always have complete ownership over the funds in their SEP IRAs.
An employee's own contributions to the 401(k) plan are always 100% vested, or owned, by the employee.
However, employer contributions to the account may be subject to a vesting schedule, a timeframe that dictates when an employee earns the right to keep the employer's contributions to their 401(k) account, even if they leave the company.
SEP plans cannot offer saver loans. An employee can take a distribution from a SEP IRA, but it is subject to income taxes and potential penalties depending on age.
A 401(k) loan allows savers to borrow money from their 401(k) retirement account, which they then repay with interest over time. Generally, savers can borrow up to 50% of their account balance, up to a maximum of $50,000, each year. It's important to note that fees may apply when taking out a 401(k) loan.
The type of plan you choose should depend on several factors, including your goals and size of your business. Generally speaking, SEP plans may be best for self-employed people or small-business owners with few or no employees. They are typically easier to set up and require less administrative work.
On the other hand, 401(k) plans are more common for larger businesses with multiple employees. They offer more flexibility in terms of contribution amounts and can include features like loans. While they may require more administrative oversight than a SEP, 401(k) plans often come with added benefits, such as employer matching, that can be attractive to prospective employees and help with recruitment and retention efforts. Plus, if you partner with a service provider like Vestwell that offers 3(16) fiduciary services, they will handle much of the administrative work for you.
Choosing the right retirement plan for your business is essential for both your own financial security and your employees’ well-being. Whether you're starting from scratch or considering a switch from a SEP plan to a more flexible 401(k), your business's specific needs, size, and growth projections should guide your decision.
Need help choosing a plan for your business? Vestwell’s team of experts can help you design a retirement plan tailored to your company’s goals and objectives. Our modern, digital retirement plan platform takes the hassle out of setting up and administering an employer-sponsored retirement plan. Click here to get started.