SEP IRA Vs. 401(k) Plan

Retirement savings is a key ingredient of financial planning.

Retirement savings is a key ingredient of financial planning.

Retirement planning is a key component of any well-designed financial plan, and the longer your money has time to grow, the more you will have when retirement time rolls around. The sooner you start setting money aside, the bigger your nest egg will likely be. The federal government created retirement programs that offer tax advantages for employers and tax incentives for employees, just for saving for their own retirement. These plans include SEP (Simplified Employee Pension) IRAs and 401(k) plans.

Eligibility

SEP IRA and 401(k) plan accounts are owned by the employee, who can choose between a range of investment options. Employees must be at least 21 to participate in either of these these plans. Employees in SEP IRA plans must have worked for the employer during three of the past five years and earned at least $550 in 2010. This earning requirement also applies to 2011. Employees become eligible for their company's 401(k) plan after one year on the job. There is no minimum income requirement for 401(k) plans.

Contributions

Employers have to fund every eligible employee's SEP IRA account at up to $49,000 or 25 percent of the employee's total compensation for the 2010 tax year, whichever rate is less. The 401(k) is an elective wage-deferral plan funded primarily by the employee. Employees can contribute to their SEP IRA or 401{k} plan, but are not required to do so. Employers may elect to make matching contributions to the employee's 401(k) plan but do not contribute unless the employee does.

Tax Advantages

Employer contributions to a SEP IRA account are not considered taxable income to the employee. Gains or losses in the SEP IRA account are not taxed until they are withdrawn. Funds withdrawn from the SEP IRA after age 59 1/2 are taxed as ordinary income at the account holder's current tax rate in the withdrawal year. Employee contributions to a 401(k) plan are made with pretax dollars. The employee's reportable income is reduced by the amount of her contribution, which effectively reduces her current tax liability. Gains or losses in the 401(k) plan account, including any matching contributions made by the employer, are not taxed until they are withdrawn. Funds withdrawn after the account holder reaches 59 1/2 are taxed as ordinary income.

Tax Penalties

SEP IRAs and 401(k)s are tax-advantaged retirement programs that are expected to be for the long term. You can withdraw funds at any time, but withdrawals made before age of 59 1/2 are taxed as ordinary income and result in a 10 percent tax penalty. Plan participants can make early withdrawals from a 401(k) plan without a tax penalty for financial hardships, such as those resulting from medical or funeral expenses.

About the Author

After attending Hardin Simmons University, Kay Dean finished her formal education with the Institute of Children's Literature. Since 1995, Dean has written for such publications as "PB&J," Disney’s "Family Fun," "ParentLife," "Living With Teenagers" and Thomas Nelson’s NY Times bestselling "Resolve." An avid gardener for 25 years, her experience includes organic food gardening, ornamental plants, shrubs and trees, with a special love for roses.

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