401(k) or SEP: Which is the right plan in 2023?

Although a SEP promises simplified administration, a 401(k) provides additional contribution options along with plan flexibility, increased tax efficiency, and the ability to target participant Profit Sharing contributions. Both plans are strong options for retirement savings and it will come down to several factors such as, net income, payroll employees, and age to determine which plan will bring the most benefit.

Income less than $268K

Net income is a key differentiator in the SEP vs 401(k) equation. If an owner draws a W-2 or has net income less than $268k, it is likely a 401(k) plan will provide larger contribution options due to the deferral option.

The way the company is set up will also make a difference in how the math shakes out. Is the company set up as an sole proprietorship/owner-only or is it an S-corp?

Employees on Payroll

An SEP requires the same percent to be given to all eligible employees, whereas a Profit Sharing plan can increase contributions to select participants and potentially reduce required contributions to others. This is important for companies who have a wider salary range amongst employees or who have diverse roles and responsibilities. Perhaps an owner wants to over variable percentages for different roles.

Let’s take a look at two scenarios where it may be unclear whether an SEP or 401(k) would be the better option.Example #1: Sole ProprietorHoward House is a Realtor that makes approximately $150k in Schedule C (Net Income) per year. Since he is taxed as a Sole Proprietor, both a SEP and Profit Sharing allocation would be reduced due to self-employment tax adjustments.

Winner = 401(k)In this scenario the 401(k) Deferral provides a much greater contribution advantage. As you can see in the graphic below, Howard would be eligible to contribute an additional $22,500 in a 401(k) with Profit Sharing plan.

Example #2: S-CorpThe owner of Denise’s Dandelions pays herself a salary of $60k/yr. and has two employees who receive $25k/yr. See graphic below for breakdown.

SEPDenise is limited to a contribution of 25% of W2 Salary, which amounts to $15,000 and since a SEP requires a proportional contribution to be made to all participants, she is required to give 25% to her employees as well, totaling $12,500.401(k) & Profit Sharing

Denise, who is over age 50, can defer $30,000 in addition to making a Profit Sharing allocation; amounting to a $45,000 total contribution for herself! Denise would have had to increase her W2 to $164k to receive a comparable SEP contribution, resulting in much higher payroll taxes. In the end, the flexibility of the Profit Sharing only requires her to make a 5% contribution to her employees ($2,500)

Winner = 401(k)A 401(k) w/ Profit Sharing will allow Denise to allocate much more to herself and minimize required contributions to her employees.

In conclusion, it’s important to take into consideration net income, payroll employees, and age to determine which plan is the best option.

Want to get a 401(k) or SEP plan started for your organization? Reach out to our team and we’ll get you started!

This information is provided as general guidance and may be affected by changes in law or regulation. It is not intended as accounting or legal advice. If you have questions please reach out to our team.