Simplified Employee Pensions or SEPs are generally marketed to small businesses based on two benefits:
- Low costs: there is minimal administrative work needed, including no need for an annual Form 5500 filing.
- Contribution flexibility: there is discretion on the part of the owner to decide the amount of the annual contribution, including the ability to make no contribution at all.
SEPs can be easy to establish and maintain, require no annual filings or compliance testing, and reduces participant education which can overwhelm smaller employers without dedicated HR or benefits staff or advisors who don’t specialize in retirement plans.
Although SEPs can be beneficial, there are certain types of small businesses that may want to evaluate a 401(k) plan in comparison to a SEP. Some small business owners may find that a 401(k) plan is better suited to meet their objectives when considering three factors: (1) contribution allocation; (2) maximum contribution deduction; and (3) eligibility and vesting conditions.
Potential Clients
There are three profiles of small business owners who should assess the three factors in determining whether a SEP or a 401(k) plan is best for their circumstances.
- Victoria has run her own business for years. She has no employees and doesn’t plan on hiring any time soon. Her revenue has stabilized and she wants to start saving for the future.
- Kelly runs her business with three part-time employees. Revenue has increased over the past few years and she is ready to save for her eventual retirement.
- Emily just started her company and already had to hire an employee. She will need to hire again soon and believes a retirement plan may help in recruiting good talent. She is still trying to make ends meet and wants to spend as little as possible on a retirement plan. Emily is unlikely to save for herself at this time and doesn’t want to provide any employer contributions to the others.
Contribution Allocation
SEPs may be flexible in deciding the total contribution amount, but there is only one method for allocating the contribution (i.e., who gets what amount). All eligible employees, including the owner, must receive the same percentage of compensation (up to 25%) if a contribution is made for the year. In contrast, a 401(k) plan has several methods for allocating employer contributions each year.
For owner-only small businesses, like Victoria, this isn’t an issue because the owners are the only ones receiving an allocation. On the other hand, this may be a critical issue for small businesses with employees, like Kelly and Emily.
To illustrate, the table below details the differences between a SEP and 401(k) plan if Kelly wants to contribute 20% of her compensation to a retirement plan.
| Compensation | SEP | 401(k) Plan | |
|---|---|---|---|
| Kelly | $100,000 | $20,000 (20%) | $20,000 (20%) |
| Employee 1 | $40,000 | $8,000 (20%) | $2,000 (5%) |
| Employee 2 | $30,000 | $6,000 (20%) | $1,500 (5%) |
| Employee 3 | $20,000 | $4,000 (20%) | $1,000 (5%) |
| Total | $190,000 | $38,000 | $24,500 |
In a SEP, a $20,000 contribution for Kelly would require $18,000 in contributions to other employees. However, the same $20,000 contribution for Kelly would only require $4,500 in a 401(k) plan (depending upon Kelly’s age in comparison to the other employees).
This may be an even bigger issue for Emily who isn’t financially ready to make any employer contributions to her employees. Emily just wants a plan for employees to be able to save for themselves through salary deferrals (i.e., amounts deducted from pay to be contributed to the plan).
Salary deferrals are not permitted in a SEP – only contributions by the employer. On the contrary, salary deferrals are permitted in a 401(k) plan. Therefore, Emily may find that a 401(k) plan is more useful for recruiting purposes as employees are able to save on their own.
Maximum Contribution Deduction
Although owner-only businesses like Victoria aren’t concerned with allocation methods, they may need to consider the amount of compensation required to meet the maximum contribution limit which is still deductible for their small business. Further, owners over the age of 50 can save more in a 401(k) plan than they can in a SEP.
A SEP contribution for any employee, including the owner, cannot exceed 25% of that individual’s compensation for any given year. Although a 401(k) plan is also limited to 25% of compensation for deduction purposes, salary deferrals are not included in the 25% calculation. Furthermore, a 401(k) plan may allow individuals over the age of 50 to contribute additional contributions each year. All of these contributions would be tax deductible for the small business.
| 401(k) Plan (in 2025) | SEP (in 2025) | |
|---|---|---|
| Max contribution | $70,000 | $70,000 |
| Compensation needed for max contribution | $186,000 (~$232,500 if self-employed*) | $280,000 (~$350,000 if self-employed*) |
| Salary deferral limit | $23,500 included in max contribution of $70,000 | Not permitted |
| Catch-up contribution – over age 50 | $7,500 | Not permitted |
| “Super” catch-up contribution – between ages 60-63 | Additional $3,750 ($11,250 total catch-up) | Not permitted |
* Earned income from self-employment requires a special calculation in which the contribution is aggregated with taxes. The calculation is approximately 20%, instead of 25%.
Expanding on the data in the table, Victoria needs $280,000 in order to contribute the max of $70,000 (280,000 x 25%) in a SEP. However, she only needs $186,000 to reach the maximum in a 401(k) plan. The difference is the ability for her to make salary deferrals to the 401(k) plan – up to $23,500 in 2025. These salary deferrals are fully deductible by the small business and are not included in the 25% of compensation calculation. Excluding the salary deferrals from the max contribution ($70,000 – $23,500 or $46,500 in 2025) results in Victoria only needing $186,000 to maximize deductible contributions to the plan (186,000 x 25% = 46,500). Furthermore, if Victoria is over the age of 50, her max contribution to the 401(k) plan is $77,500 (compared to $70,000 in a SEP) and could be as high as $81,250 if she is between the ages of 60-63.
Eligibility and Vesting Conditions
For small businesses with employees, the use of eligibility and vesting conditions could significantly lower the costs of a 401(k) plan over a SEP. In a SEP, employees are eligible if they have worked one hour in at least three of the last five years for the company and earn at least $750 (in 2025). In a 401(k) plan, eligibility can be delayed until an employee works 1,000 hours in a 12-month period. If an employee never works over 1,000 hours in that period, they are not eligible for employer contributions.
Here is Kelly’s table under the Contribution Allocation section.
| Compensation | SEP | 401(k) Plan | |
|---|---|---|---|
| Kelly | $100,000 | $20,000 (20%) | $20,000 (20%) |
| Employee 1 | $40,000 | $8,000 (20%) | $2,000 (5%) |
| Employee 2 | $30,000 | $6,000 (20%) | $1,500 (5%) |
| Employee 3 | $20,000 | $4,000 (20%) | $1,000 (5%) |
| Total | $190,000 | $38,000 | $24,500 |
All three employees are part-time, and each likely worked at least one hour in each of the last three years. Therefore, with a SEP, Kelly likely must contribute $18,000 to her part-time employees in order to make a $20,000 contribution for herself. On the other hand, those employees may never work more than 1,000 hours in a 12-month period. If so, Kelly wouldn’t need to make an employer contribution for them to a 401(k) plan. This results in Kelly being able to make a $20,000 contribution for herself with $0 contributions to her three employees.
Even if Kelly’s part-time employees do work over 1,000 hours and are eligible for employer contributions in the 401(k) plan, they may be required to work up to a certain amount of time before they become vested in those contributions. If an employee leaves the company before reaching full vesting, some or all of the account is forfeited and can be used by Kelly for future contributions. In a SEP, an employee is immediately vested in the contribution. Therefore, as soon as an owner contributes to a SEP, the employees are entitled to those funds. Contrary to a SEP, a 401(k) plan allows the employer to control who is entitled to the funds even after contributions are made.
401(k) Plans May Be Advantageous For Certain Small Businesses
SEPs can work for small businesses due to their low cost and contribution flexibility. However, specific types of small businesses should look into 401(k) plans if they are considering: (1) contribution allocation; (2) maximum contribution deduction; and (3) eligibility and vesting conditions.
If you have a Victoria, Kelly or Emily as a potential client, these three features may support that a 401(k) is a better suited option than a SEP. In helping these small business owners in assessing these and other factors, you ensure they achieve the best retirement outcome.
About the Author
Brian Furgala, Esq., CPC, QPA is Senior Director, Retirement Services Strategy for PenChecks, a leader in outsourced retirement plan distribution processing and Automatic Rollover/Missing Participant IRAs and related services. His broad experience as an ERISA attorney and senior executive for several leading retirement plan service providers gives him a unique perspective on the industry.
The views expressed in this article are those of the author and do not necessarily represent the views of PenChecks Trust®, its subsidiaries or affiliates.
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