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Friday, March 03, 2006

SEP-IRA versus Self-employed 401(K)

Last year, I set up a self-employed 401(K) for my wife, who is a business broker. I considered two options: the older and more well-known SEP-IRA, or a Self-employed 401(K). Self-employed 401(K)s are fairly new, and many professionals don't yet know much about them. Also, while my experience was that a self-employed 401(K) wasn't any harder to set up than any other brokerage account, many people think "setting up a 401(K)" is Really Hard, so you have to be clear that you're looking at a self-employed account, not a generic 401(K) for multiple employees, which is rather troublesome to set up.

Like any tax-associated thing, there's lots of niggling detail that may be relevant in some circumstances, but I'll ignore that and say that anyone investigating these for themselves should do the relevant research.

In our circumstances, we live on my income and save my wife's income. So, maximizing the amount we could set aside and defer taxes on was the primary concern, since my wife's income is taxed at a rather scary rate somewhere between 45% and 50%:

15.7% Self-employment tax
28% Federal tax ($120K+ bracket)
9.3% California state tax

Calculating the exact percentage is tricky, because some taxes are deductible from others (half the SE taxes are deductible from Fed and CA taxes, and the CA taxes are deductible from Fed taxes if you itemize deductions with Schedule A, which we do), but it's definitely scary, so we wanted to shovel as much of my wife's income into a tax-protected account as we could legally get away with. And for the tax watchers out there, we know that we don't avoid self-employment taxes this way, but we do avoid the other taxes.

For us, the best way to maximize the amount we put into the account was with the Self-employed 401(K).

Anyway, this comparison does a good job of comparing SEP-IRA versus Self-employed 401(K), particularly the "Higher contribution limits" a bit down on the page. (I don't have any connection with Fidelity other than having the 401K there; they were one of the earliest big brokerages to set them up. I like their charts since they're clear and have numbers.)

The main point is you can put your first $15000 of self-employed profit (20K if you're over 55), after SE taxes, directly into the 401(K), while with a SEP, you can only put $3750 of the first $15K into the account. After this, you can put 25% of your profit after SE taxes as your "employer profit-share". So, while the maximums you can set aside are actually identical at $42,000, you can set aside more at a lower income level with a self-employed 401(K). So, if you have $50K of self-employed profit and are, say, 40, you can put $24293 in the 401(K), while you can only put about $9293 into a SEP. (Numbers from the calculators on Fidelity)

Some important asides:

o Unlike self-employed 401(K)s, SEP-IRAs can be used even if you have a regular job with an existing 401(K) or pension plan. So, if you are an employee and have additional self-employed income, you may want to look at the SEP-IRA.
o Self-employed 401(K)s can't be used if you have any employees outside your family in your biz.

The Roth option:

This year, the Roth 401K has become available, and the law does allow a Self-employed Roth 401(K) as well. As of my last check, Self-employed Roth 401(K)s aren't available from Fidelity yet, but I'll keep checking and hope to set up one this year.

These would have the following useful properties:

o The first $15K (or $20K if you're over 55) could be put into the "Roth part", which has the same tax treatment as a Roth IRA.
o The "employer match" part would go into a "normal" 401K, which has the same tax treatment as existing 401Ks or Traditional IRAs.

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