SEP-IRA Vs. Self-Employed 401(k)

A couple of months have passed since my 30 th birthday, and that means getting started on some of my  money resolutions for the year. One of those resolutions was choosing an additional  savings plan for retirement.

Currently, I have an IRA that I'm planning on - and getting close to - maxing out for the year. Last time I wrote about my financial goals, I planned to save more for retirement by opening a self-employed 401(k).

Since then, I've picked up “The Money Book for Freelancers” (thanks,  El Nerdo!). Authors Joseph D'Agense and Denise Kiernan introduced this novice freelancer to the SEP-IRA.

Actually, the authors have an entire section on retirement options for the self-employed, but the SEP-IRA stood out to me as a worthy contender for my situation. Since reading, I've been comparing the two accounts, SEP-IRA and Solo 401(k), noting their advantages and disadvantages. I've been working toward making a decision, and I thought I'd share some of the basics of what I've learned.

401(k): Potentially higher contribution limits

After Fidelity sent me some info on self-employed  401(k) plan, I inquired about the SEP-IRA. I found out that, while both plans have a cap of $51,000 (for 2013), the 401(k) allows you to contribute more of your salary  below that cap.

Both plans allow you to contribute 25 percent of your earnings (for sole proprietors, the contribution is 20 percent). But the 401(k) allows an  additional $17,500 in salary deferrals. So, depending on your salary and how much you want to contribute, the 401(k) might be a better option, because you can save more money in it.

Jonathan Ping, who has contributed to Get Rich Slowly  in the past, once wrote about the differences in contribution limits between these two types of accounts. The  article was written in 2006, and while limits have changed, the fundamental idea is the same:

“…you can make very little self-employed income and basically defer it all, which you can't do with the SEP-IRA. This gives you that added flexibility which is especially beneficial for those who have some self-employed income as secondary income and want to get the most tax advantages.  For example, if you made $15,000 of eligible compensation, you could sock all $15,000 of it away with a Self-Employed 401(k), but only $3,750 with a SEP-IRA.”

To me, this is the most noteworthy difference between the two plans - the  potentially higher contribution limits. Both accounts are tax-deductible and tax-deferred, so I can see how the additional $17,500 would be a big draw for the 401(k).

However, I personally don't plan on being able to contribute more than 25 percent of my salary for retirement anytime soon, so the potential may be lost on me. Perhaps this will change in the future, but for now, I don't think I'll reach the 25 percent limit.