What small business owners need to know: Changing a SEP IRA to a 401(k) plan

Image: What small business owners need to know: Changing a SEP IRA to a 401(k) plan

Small business owners who decide to set up a retirement plan to benefit themselves and their employees may consider a Simplified Employee Pension (SEP) IRA. Not only is it a low-cost option for the employer, but it doesn’t require the same IRS reporting and plan testing involved in running conventional retirement plans. As a business grows and plan sponsors are looking to beef up their employee benefit packages, employers may begin to feel they’re outgrowing the SEP IRA and want to make the change over to the more flexible and robust 401(k) plan.

Three questions small business owners have about SEP IRA vs 401(k) 

It’s important to consider all the factors involved in making the decision to set up a SEP IRA or discontinue a SEP IRA and set up a new 401(k) plan. Answering these key questions will help employers through the process and ensure they get off on the right foot:

1. How is a SEP IRA different from a 401(k) for small businesses?

A SEP IRA serves as a cost-effective option for small businesses who want to contribute to their retirement savings as well as those of their employees. They are simple to administer and do not require the same discrimination testing that 401(k) plans do (with the exception of safe harbor 401(k) plans). Employers do not have to make any official commitment to annual contributions to the account, and contribution limits are high compared to a Simple IRA or Roth IRA. However, the limitations on a SEP IRA can impact its effectiveness as a retirement savings vehicle for employees and the benefits of offering the plan for the employer:

  • SEP IRA plans only allow the employer to make contributions to employee accounts—employees are not able to contribute.
  • Employer contributions each year max out at 25 percent of compensation or up to $66,000 for 2023, whichever is lesser.
  • Employers who contribute to their own account are also required to make proportional contributions for each eligible employee.
  • Roth contributions are not allowed, meaning employers are not able to pay taxes on contributions now and take distributions tax-free in retirement.
  • All funds contributed to the plan are immediately vested.

SEP IRA vs 401(k) for small business owners

  • Maximum employee contribution limits (2023):
    • SEP IRA: $0
    • 401(k): $22,500, plus $7,500 in catch-up contributions for participants 50 and older
  • Maximum total contribution limits (employer + employee) (2023):
    • SEP IRA: $66,000
    • 401(k): $66,000
  • Tax advantages

    Both plans offer potential tax savings to plan sponsors through tax credits and tax-deductible employer contributions. However, employees are unable to make contributions to a SEP IRA and are unable to take advantage of tax benefits that are available with a 401(k).

    For employees, the SEP IRA offers considerably less flexibility than a 401(k) plan. Employees are unable to make contributions , and therefore are not able to take advantage of tax-deductible deferrals that are offered through a 401(k)—plus plan loans are not an available feature. Employees may still take early distributions from a SEP IRA at any time, and are not required to receive approval from the plan sponsor, but they are still subject to the same 10 percent penalty if funds are withdrawn before age 59½.

2. Can business owners contribute to a SEP IRA and a 401(k) in the same year?

Generally, no. If they maintain a 5305-SEP (the most common type), an employer cannot offer any other qualified plans. An employer offering either a prototype SEP or individual designed SEP can offer both types of plans in the same year. When both a SEP and a qualified plan can be maintained by the employer, there are additional considerations. If both a 401(k) plan and a SEP IRA are offered by the same business, business owners can contribute to both plans simultaneously, however contributions between the two plans are limited to the maximum of 25 percent of compensation or up to $66,000 (whichever is lesser). Top Heavy testing does need to be coordinated between the two plans. If a business owner has a SEP for their business and is participating in a 401(k) as an employee of a completely unrelated business, there is no coordination of limits.

 What is the deadline for rolling over a SEP IRA to a 401(k) this year?

There are no deadlines involved in rolling over funds from a SEP IRA to a 401(k). The rules for rolling over a traditional IRA into a 401(k) are generally the same for a SEP IRA. Employees can request a distribution from a SEP IRA at any time, and if it’s performed as a rollover into another qualified plan like a 401(k) or traditional IRA there will be no tax penalty. All employees will have the choice between taking the account assets as a distribution (with any accompanying penalties, depending on their age), and rolling the funds into another plan (either the newly established 401(k) or their own individually established traditional IRA).

It is also not a requirement to notify the Internal Revenue Service (IRS) about the termination of a SEP IRA—employers should simply notify the plan’s administrator that they wish to terminate the plan and direct them on what they’d like to do with their assets.

Interested in changing your SEP IRA to a 401(k)?
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3. How do I roll my SEP IRA over to a small business 401(k) plan?

Getting a small business 401(k) started and rolling SEP IRA funds into the new plan is simple at Ascensus. Our installation process is focused on the needs of small business owners with an assigned Installations and Conversions representative who is there to guide plan sponsors along the way. From there, employers have access to our customer care team who is available to answer any setup or plan questions from both plan sponsors and employees.

For more information about our retirement savings plan or to explore plan conversion options, contact us at 800-345-6363.