The W-2 Wage Misconception in a SEP-IRA vs. 401(k) for a Small Business

Two W-2s, 12 employees and a $6,000,000 offer

Boyd and Tracy are a hypothetical couple, aged 61 and 59, who own a landscaping supply S corporation. Their January W-2s show $200,000 and $100,000 in wages. The payroll register shows $600,000 paid to 12 eligible employees. A private equity firm has floated $6,000,000, and they expect the buyer's letter of intent within weeks.

They previously funded a SEP-IRA at 10%. That allocated $20,000 to Boyd and $10,000 to Tracy, while requiring $60,000 for their staff. With 1 or 2 high-earning years left before closing, they need to shelter more personal income without draining company cash on non-owner contributions.

Moving forward requires an orderly sequence. First, gather the prior year W-2s and the full payroll register. Second, divide total staff compensation by owner wages to see the exact multiple each SEP contribution creates. Third, request a safe-harbor 401(k) proposal showing administrative fees and final adoption cutoffs. Fourth, consult transaction counsel on how a buyer wants qualified plans addressed before closing.

Corient Wealth Management does not pick the plan with the biggest headline deduction. We price each option twice: the deduction it gives Boyd and Tracy this year, and the tax due when those balances come out 15 or 20 years from now.

Four beliefs about SEP-IRA vs. 401(k) plans for a small business

Each of the four beliefs below changes the dollar figures in Boyd and Tracy's example, usually by tens of thousands of dollars in staff contributions or lost deductions.

Belief: A SEP-IRA is always the economical choice. Reality: The owner's chosen contribution percentage applies equally to all eligible staff. When a business carries $600,000 in employee pay alongside $300,000 in owner wages, each dollar saved by the owner forces $2 into worker accounts.

Belief: S corporation pass-through profits raise annual limits. Reality: Plan contributions depend strictly on W-2 earnings. Distributions reported on Schedule K-1 do not count as plan compensation under IRS rules.

Belief: A business sale enables an outsized contribution. Reality: Capital gains from an equity or asset transfer pass through tax schedules without altering W-2 wages, leaving annual plan limits completely unchanged.

Belief: A 401(k) plan transfers automatically to the buyer after a stock sale. Reality: Buyers almost universally demand corporate termination by board resolution before the closing date to avoid assuming plan liabilities.

At 61, Boyd can put $41,750 into a 401(k)

Starting from Boyd and Tracy's January payroll reports reveals a clear divergence between the two structures. Maxing out a SEP-IRA at 25% provides $50,000 to Boyd and $25,000 to Tracy, totaling $75,000. Because staff receive an identical percentage, that choice obligates the company to contribute $150,000 to the 12 employees ($600,000 × 25%).

A safe-harbor 401(k) shifts those economics entirely. Under 2026 limits published by the IRS, each individual can defer $24,500. Boyd qualifies for an $11,250 catch-up contribution designed for workers aged 60 through 63. Tracy adds an $8,000 catch-up for individuals aged 50 and older. Adding a 3% safe-harbor nonelective contribution provides $6,000 to Boyd ($200,000 × 3%) and $3,000 to Tracy ($100,000 × 3%). Boyd puts away $41,750, and Tracy puts away $35,500, yielding $77,250 for the household.

The tax treatment also splits. Because Boyd's prior-year FICA wages reached $200,000, surpassing the $150,000 statutory mark, the IRS requires his $11,250 catch-up to be Roth. That money generates no immediate deduction, though qualified distributions emerge tax-free later. Tracy's $100,000 wage base falls below the line, so her $8,000 catch-up stays pre-tax. Their total pre-tax reduction comes to $66,000 ($30,500 from Boyd plus $35,500 from Tracy). Meanwhile, the required 3% company contribution for the 12 employees costs just $18,000 ($600,000 × 3%).

At higher personal wages, a SEP-IRA matches or exceeds the 401(k) total for an owner, but the mandatory staff cost remains a flat 25% of payroll.

The switch shifts the household's annual retirement savings from $30,000 under their old 10% SEP to $77,250, while cutting company cash outflows for staff from $60,000 down to $18,000. In evaluating alternative exit structures, our team assesses these numbers alongside broader strategies like business exit planning and cash balance plans.

$288,000 in wages before a SEP reaches $72,000

An owner needs exactly $288,000 in W-2 wages for 25% to reach the $72,000 SEP-IRA ceiling. On the 401(k) side, the $8,000 standard catch-up starts at age 50, and the larger $11,250 catch-up is available only from age 60 through 63. Boyd has 3 years of the higher tier left, and Tracy reaches it next year. Both were born after 1959, so neither faces required minimum distributions before age 75.

What happens if the bookkeeper counts K-1 distributions?

An unauthorized contribution occurs whenever a company uses pass-through business distributions rather than payroll compensation to calculate retirement funding, triggering annual tax penalties until corrected.

A bookkeeper's SEP calculation that adds $80,000 of K-1 distributions to Boyd's $200,000 W-2 produces a $70,000 contribution instead of $50,000. The $20,000 excess draws a 6% excise tax, $1,200, for each year it stays in the IRA. Resolving it demands filing amended returns, extracting the excess deposits, and forfeiting accrued growth.

Catch it by checking every contribution against 25% of W-2 wages before the money moves. If your eligible employees' total pay is larger than the owners' combined W-2 wages, every dollar you put into a SEP drags more than a dollar into staff accounts, so price a safe-harbor 401(k) first.

• Each owner W-2 compensation figure
• Spouse on company payroll with verified duties
• Eligible staff count and total annual pay
• Existing plan legal documents and adoption deadlines
• Prior-year FICA earnings relative to $150,000
• Anticipated acquisition timeline versus plan year end

When Tracy or the children inherit the accounts, who pays the tax?

Account type determines beneficiary rights and long-term tax exposure. A 401(k) carries federal statutory protections that mandate the surviving spouse receive the balance unless they provide signed, notarized consent. A SEP-IRA relies on standard IRA beneficiary documents, which do not impose federal spousal consent, although state community property laws may apply.

Under current federal law, non-spouse beneficiaries such as adult children must empty inherited pre-tax accounts within 10 years of the owner's death. If a large traditional balance lands on children while their own salaries are at their highest, federal and state income taxes can take more than a third of it. Market assets involve risk of loss, and past performance does not guarantee future results.

Boyd's mandatory Roth catch-ups create an offset. Directing $11,250 each year into a Roth sub-account across 3 years builds a reserve that heirs can withdraw completely free of income taxes. What initially seemed like a drawback under IRS rules turns into a tax-free vehicle within estate planning for owners.

What happens if the plan is still open at closing?

An open retirement plan creates severe legal exposure during an acquisition, requiring formal termination by corporate resolution prior to the transaction closing date to permit penalty-free rollovers.

In an asset sale, the seller's legal entity remains intact while the buyer acquires equipment, contracts, and workforce. Boyd and Tracy retain their corporate sponsor, terminate the 401(k), and roll vested funds into traditional or Roth IRAs without complication.

A stock transaction passes the existing corporate entity and all plan obligations directly to the buyer. If the board does not formally terminate the 401(k) prior to closing, the business runs into the IRS successor plan rule. If the acquirer operates another defined contribution plan within 12 months, participants cannot roll over their deferrals. A SEP-IRA avoids this hurdle because accounts belong to the employees, letting the company fund the sale year up to its tax filing deadline.

Boyd and Tracy chose a safe-harbor 401(k). Boyd's catch-up goes to Roth, Tracy's stays pre-tax, and their counsel prepared a board termination resolution ready for signature before closing. We coordinate these transactional moves alongside tax on a business sale, family business succession, and investing sale proceeds.

• Buyer requirements regarding pre-closing corporate plan termination
• Consequences of mid-year cancellation on safe-harbor protections
• Final Form 5500 filings and third-party administrator costs
• Specific W-2 wage box identified as plan compensation
• Prior-year FICA figures determining mandatory Roth status
• Final calendar deadline to establish the chosen plan

The W-2 math you can run alone, and the deal timing Corient Wealth Management reviews

You can run the initial payroll calculations on your own by comparing 25% of W-2 pay against deferrals, age catch-ups, and a 3% safe-harbor match. That confirms whether staff overhead makes a SEP-IRA economically unfeasible.

Adopting a new 401(k) involves setup costs, annual testing, and closing filings, which may not justify the effort if an exit closes within 3 months. When timing is tight, or for businesses without employees, a SEP-IRA remains a practical alternative.

The team at Corient Wealth Management reviews the transactional elements: coordinating termination dates with transaction counsel, optimizing the Roth mix across retirement, and coordinating structural questions covered in asset sale vs. stock sale: what each costs the seller in tax and installment sale of a business: spreading the tax cost over years.