3 Reasons to Consider a 401(k) Instead of a SEP IRA
By Jeffrey Levine, IRA Technical Expert
Follow Me on Twitter: @IRAGuru4EdSlott
It’s Small Business Week at The Slott Report with articles Tuesday, Wednesday and Friday dealing with the issues small business owners and their employees face and the questions they need answered. Click here to read Tuesday’s article on the advantages of a SEP IRA and if a small business owner still has time to set one up for 2014.
One of the most popular small business retirement plans is the SEP IRA. In contrast to other potential options for small businesses, such as a 401(k), the SEP IRA is often favorable. SEP IRAs, for instance, are generally less complex to establish and maintain, and they are also generally lower in cost to operate.
That said, there are many reasons you might consider using a 401(k) for your small business instead of a SEP IRA. Here are three of them:
- General Creditor Protection May Be Enhanced
401(k)s generally receive creditor protection under a federal law known as ERISA. This creditor protection is about as good as it gets. Other than an ex-spouse who receives funds pursuant to a QDRO (qualified domestic relations order) due to a divorce and the IRS itself – in the form of a levy for unpaid taxes – your 401(k) funds are fairly bullet-proof from a creditor protection standpoint. Even if you have $10 million in a 401(k) the entire amount is typically off-limits for angry creditors. In contrast, a SEP IRA is an IRA and receives general creditor protection under state law. In many states, that protection is comparable to the protection that is afforded to 401(k) plans under ERISA. In some states, however, the protection afforded to SEP IRAs under state law is significantly weaker than the ERISA protection afforded to 401(k) assets. So, if creditor protection is an important concern to you, you might want to check your state laws and if creditor protection would be much stronger in a 401(k), that might be a reason to choose it over a SEP IRA.
Note #1: As noted, the rules discussed above relate to general creditor protection (non-bankruptcy situations). In bankruptcy situations, both 401(k) assets and SEP IRAs are generally fully protected.
Note #2: The ERISA creditor protection for 401(k)s described above does not apply to Solo 401(k)s, where you are the only plan participant (or where the only other participant is your spouse).
- You Can Establish a Vesting Period
Retaining good personnel is important to any business, but even more so to a small business. If you have four key employees and one of them leaves, you’ve just lost 25% of your key staff. That can be very difficult to replace timely and cost effectively. Therefore, anything you can do to incentivize your key employees to stay with you for as long as possible is generally in your best interest. Offering any type of retirement plan can certainly help serve this goal, but a 401(k) may provide a strategic edge.
If you offer a 401(k) plan, you can include what’s known as a vesting schedule in the plan. A vesting schedule is used to determine how much an employee actually owns of certain plan assets, like an employer match, that were contributed to their plan account by their employer. For instance, in one type of vesting, known as cliff vesting, if you leave your employer before the end of the cliff vest period, you will forfeit any amounts your employer contributed to your plan (you are always 100% vested in your own salary deferrals though). For instance, let’s say there’s a three-year cliff vest schedule as a part of your plan and during your first two years of employment, your employer contributed $5,000 of matching contributions to your plan account. If you leave before the end of your third year, you’ll forfeit that $5,000.
Now perhaps you’re asking yourself, “Why don’t I just add a vesting schedule to a SEP IRA instead?” The simple answer is because you can’t. A SEP IRA is still a type of IRA and a person is always 100% vested in their own IRA. As a result, a 401(k) with a vesting schedule can be a more effective tool in reducing employee turnover than a SEP IRA.
- You May Be Able To Contribute More to a 401(k)
SEP IRAs can be very limiting when it comes to making contributions. If, for instance, you are a sole proprietor and have a net business profit at the end of the year of $18,000, you can’t contribute the full $18,000 to a SEP IRA. Not even close. The best you can do is about $3,300 (just take my word on it).
In contrast, if you establish a 401(k), you can sock away quite a bit more. Instead of maxing out at about $3,300 with the SEP IRA, you could be saving about $16,700 with a 401(k). The tax savings on these increased contributions and the benefit of the tax-deferral you’ll receive on those assets in future years can make up for any additional costs of running the 401(k) plan instead of the SEP IRA.
As always, deciding what’s in your best interest is a complicated matter and one that should not be taken lightly. If you are a small business owner and want to know which plan makes the most sense for you, be sure to speak with a qualified professional, such as a knowledgeable CPA, financial advisor or TPA (third party administrator).
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