Fulcrum Self-Directed establishes self-directed IRA and 401(k) plans so clients have the greatest freedom and flexibility legally provided under IRS rules, and the IRA LLC Manager or 401(k) Trustee has checkbook control of their retirement funds. In establishing these plans, there are no biased or selfish interests other than assisting the client in establishing the self-directed plan that best suits their interests. One of these cases of bias may be when comparing the self-directed 401(k) to the self-directed SEP IRA.
Self-Directed 401(k) vs. Self-Directed SEP IRA
While both of these plans can certainly be self-directed, a comparison of the two really goes back comparing the 401(k) to an IRA. The SEP, as a Simplified Employee Pension plan, is still an IRA and must still comply with many of the requirements set forth for IRA plans. While the contributory limits are definitely potentially higher than that of the Traditional or Roth IRA, it is still an IRA when compared to the 401(k).
Keeping this in mind, what are the benefits of the 401(k) vs. the SEP IRA? You will find that the benefits can be substantial:
1) 401(k) Plans can be Established for the Self-Employed — Self-employed individuals with no common law employees can establish a 401(k) plan for their business. An individual can probably more easily establish a SEP IRA with less hassle and potentially have the same level of contributory benefits. On the surface then, why still establish a self-directed 401(k)?
Simply speaking, even if contribution limits were identical, the SEP is still an IRA and will not have of the same benefits afforded through the 401(k).
Rollover Funds Cannot be from an IRA or Other Non-401(k) Plan — Yes, you heard that correct and that is not an uncommon belief. Many individuals believe that in order to fund a 401(k) plan, ONLY funds from a previous employers’ 401(k) plan can be rolled over into the plan. While self-employed, they may have a Traditional IRA funds and, as such, believe that since it is an IRA funds, those funds can only fund a self-directed IRA. What plans are eligible to rollover to a 401(k): Traditional IRAs, SEP IRAs, SIMPLE IRAs (under certain conditions), 401(k) plans, 403(b) plans, 457 plans, Keogh plans and Money Purchase plans.
3) Guidance from Professionals — Simply stated, many individuals have been guided and advised that a SEP is easier to establish and less burdensome to operate. Many times these comments are well intended, but may not be factually correct or in the best interests of the individual. While the SEP may have some limited benefits over the 401(k), as a general rule, the benefits of a 401(k) will probably be better suited for the self-employed individual.
Solo 401(k) and SEP IRA
So, with some of the aforementioned reasons why a self-employed individual may incorrectly believe that they cannot establish a SOLO-K plan, let’s provide some general reasons why someone should consider establishing the Individual 401(k) plan.
1) Maximum Contribution Limits — While on the surface most people don’t see much difference in the contribution limits between a Solo 401K and SEP IRA, there are significant differences. Keep in mind that the 401(k) permits you to make employee elective deferrals AND employer profit share contributions, whereas the SEP only permits only the profit share contribution. In most cases, you will be able to defer more in contributions with the 401(k) vs. the SEP.
To keep things simple for now, let’s assume John (age 45) is a self-employed individual operating as an S-Corp and has wages of $100,000. Let’s also assume that John is interested in contributing as much as possible…whether he was using a SEP or a 401(k). In this scenario, John could have elective employee deferrals of $17,500 and the employer profit share contribution could be $25,000….or a total of $42,500. In contrast, the SEP’s total contributions would be $25,000….which do you think is better?!
Then, take in mind also that the 401(k) permits “catch-up contributions” of $5,500 if you are over the age of 50. SEP plans do not have these catch up contributions provisions.
2) Anyone Say Loan? (401(k) Loan Provisions) — When I visit with clients, my job is never to advise them on whether they should ever take a loan from their 401(k) plan, rather educate them on the ability of a 401(k) plan to exercise such loan(s). Of course, strict adherence to all IRS 401(k) loan regulations regarding the loan must be followed. But, the point in this conversation is that IF an individual ever wants the benefit of taking loans from the plan, they are out of luck with the SEP (being part of the IRA family) as it does not permit loan provisions.
3) No Custodian Relationship Required — Yes, you heard that correctly. 401(k) plans are not required to have a custodian-relationship for the plan where the SEP (as an IRA) absolutely must have a custodian in place. In addition to more freedom, less intervention from an outside custodian and, more notably, less fees to operate has to be attractive. Even IF an IRA custodian’s fees are not much, there are still fees that are going to be charged for that account. These fees do add up.
4) Don’t want an LLC? — Well, then you don’t need one…with the 401(k). You see, the 401(k) is a “trust” and, as Trustee of the Trust, the trustee can make investment decisions without the need of an LLC. As such assets are held in the name of the plan. With what is commonly marketed as the “IRA LLC” (for any type of IRA including the SEP), you are going to need an LLC for the IRA to be able to make non-traditional assets. Now, keep this in mind, in some states these LLC fees can be extremely excessive. In California the LLC filing fee is not excessive; however, the State charges LLCs $900 (I believe that is the current fee) JUST to operate the LLC on an annual basis….geesh. In States like Massachusetts and Maryland, not only are there high LLC establishment fees, but also high annual fees (e.g., annual filing fee)….to the tune of $500 establishment/$500 annual fee. This is extremely expensive.
Now, can your 401(k) plan have an LLC that, so to speak, acts like the “investment arm” of the plan. Yes. And, there may be reasons why the Trustee of the plan would desire to have an LLC for the 401(k)’s investments. But, for this conversation, the point is that the 401(k) does not require the LLC, where the IRA family (inclusive of the SEP), generally, will require the use of the IRA LLC.
5) Roth Contributions — This is a wonderful benefit to the 401(k)…the ability to make both pre-tax and after-tax (Roth) contributions…all within one plan. You do not have this option with any IRA, meaning the ability to do both pre-tax and Roth contributions all within one plan. You can make both pre-tax and Roth contributions to a 401(k) plan, whereas with a SEP the only contribution to this profit sharing plan is a contribution made in a pre-tax manner.
6) Account Flexibility to Invest in Both Traditional & Non-Traditional Assets — Can an IRA invest in both traditional and non-traditional assets…yes. But, this option is not necessarily easy for many and, quite honestly, when they find out some of the hassles associated with their IRA investing in traditional assets from a self-directed IRA….they will elect to use their self-directed IRA for non-traditional asset investing (only). However, in contrast to the IRA (and especially if structured in a certain manner) think about how flexible and advantageous to have your 401(k) be one account….one account to invest in both traditional and non-traditional assets. No need for two different accounts to accomplish your overall goal of having just one account to manage….how nice is that?!
Now saying that, your plan can certainly be established at a bank. However, you might be interested in having one account that can be hosted with highly rated financial service companies who do not charge fees for the establishment of your 401(k) account AND you have the ability to have full control of your account (i.e., controlling the retirement “checkbook”). So, literally, the ability to invest in both traditional assets from that same account.
7) UDFI — UDF what? Unrelated Debt Financed Income. In simple terms for this post, if structured correctly, your 401(k) plan can leverage investments into real estate (only) without paying taxes on gains realized from the use of leveraged funds. This is a huge benefit of the 401(k) compared to any IRA. The IRA, including the SEP, will pay taxes on gains realized from leveraged investments. For many serious real estate investors who actively utilize leverage, this reason alone is enough to establish the 401(k) (again, provided they qualify for the plan). Of course, it should be noted that any non-Roth 401(k) investment will pay taxes upon distribution from the plan.
Want more?! Generally speaking, better asset protection with a 401(k) vs. an IRA, and the possibility of having lesser penalties associated with, should they occur, Prohibited Transaction dealings within the 401(k) (vs. the IRA).