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SEP IRA vs Simple IRA: Which Retirement Plan Is Right for You?

SEP IRA and SIMPLE IRA are two popular employer-sponsored retirement plans for small business owners and self-employed individuals. Both of these plans allow you to contribute much more than you could to a traditional IRA and both offer tax advantages.

But which plan is right for you?

A Simplified Employee Pension (SEP) IRA is a retirement savings option that provides a simple approach for self-employed individuals and small business owners to offer tax-advantaged savings for themselves and their employees. Only employers can contribute to a SEP IRA.

On the other hand, a Savings Incentive Match Plan for Employees (SIMPLE) IRA is designed to help self-employed individuals and small businesses provide a low-cost retirement savings plan for themselves and their workers. Both employers and employees can contribute to it.

In this post, we’ll go over the key differences between SEP IRAs and SIMPLE IRAs, including their eligibility, flexibility, tax advantages, and more.

 

Key Takeaways

  • SEP and SIMPLE IRAs are both retirement plans tailored for small businesses and self-employed individuals.
  • SEP IRA is funded solely by the employer, while a SIMPLE IRA allows both employer and employee contributions.
  • A SEP IRA can be established by any business, while SIMPLE IRAs are designed for businesses with 100 or fewer employees.
  • Both plans have unique advantages and disadvantages, making it important to weigh the options carefully before deciding.

 

Understanding SEP IRA

A Simplified Employee Pension (SEP) IRA is a retirement savings plan designed for small-business owners and self-employed individuals to contribute to their retirement. It is created to be simple, hence the name, and requires little administration.

Contributions to a SEP IRA are made solely by the employer, and employees are not allowed to contribute. This distinguishes it from a SIMPLE IRA, which allows for both employer and employee contributions.

Contributions made by employers are tax-deductible and investment earnings within the account grow tax-deferred until withdrawal during retirement.

Finally, there is no limit on the number of employees a business can have to qualify for a SEP IRA, which makes it distinct from a SIMPLE IRA.

Eligibility for SEP IRA

Employers of any size can establish a SEP IRA, making it a versatile choice for both small businesses and self-employed individuals.

Each company can adjust employee eligibility requirements to fit their needs. However, some standard employee eligibility requirements are:

Keep in mind that an employer could choose to adjust these requirements if they choose, but can only make requirements less restrictive and not more restrictive. That means they can adjust the minimum age requirement to 18 instead of 21 in a SEP, or they could make the minimum earning to be $100 instead of $750.

 

Contributions to SEP IRA

First, only employers can contribute to a SEP IRA, not employees.

As of 2023, SEP IRA contributions are capped at 25% of employee compensation or up to $66,000, whichever is lower. To contribute the maximum amount to a SEP IRA account, you must earn an annual salary of at least $264,000.

It’s important to remember that contributions amounts are determined by employers, meaning employees have no input on how much is contributed. Employers can choose to contribute any amount or percentage of salary as long as it doesn’t exceed the annual contribution limit. An employer can also adjust your contributions throughout the year based on the business goals and income.

Once an employer decides to participate, they are required to provide all employees with an equal contribution percentage. The contributions are also 100% vested to the employees immediately.

 

Withdrawals of SEP IRA

Withdrawals from a SEP IRA follow similar rules to those of a traditional IRA. Participants can begin taking penalty-free withdrawals at the age of 59.5. Any withdrawals made before the age of 59.5 are subject to a 10% penalty.

All withdrawals made from the account, whether before or after 59.5 years of age, are subject to income tax. Finally, mandatory withdrawals, also known as Required Minimum Distributions (RMDs), begin at the age of 72.

 

SEP IRA Set-Up and Administration

One of the key benefits of SEP IRA accounts is that they are easy to set up and maintain once created. Here’s a three-step process to set up a SEP IRA:

  1. Execute a written agreement to provide benefits to all eligible employees.
  2. Disclose to employees certain information about the agreement.
  3. Set up an IRA account for each eligible employee.

SEP IRA accounts require little to no filing requirements unless updates are made to the plan requirements or contributions. You don’t need an EIN number like you do for a solo 401(k) account.

 

Understanding SIMPLE IRA

A SIMPLE (Savings Incentive Match Plan for Employees) IRA is a type of tax-deferred retirement plan specifically designed for small businesses with fewer than 100 employees. It is considered an employer-sponsored retirement plan, and both employers and employees can contribute to it.

It offers a straightforward and cost-effective way for self-employed individuals and small business owners to provide retirement benefits to themselves and their employees. The plan is designed with relatively simple application and administration processes.

 

Eligibility for Simple IRA

Simple IRAs are designed for small businesses and self-employed individuals to contribute to a retirement plan. Below are some restrictions on who can establish a simple IRA:

  • Have less than 100 employees
  • The employer cannot maintain any other qualified retirement plan (such as a 401(k)) concurrently with the SIMPLE IRA.

Similar to SEP IRA, the employee eligibility requirements for SIMPLE IRA are set by employers.

Some standard employee eligibility requirements for a SIMPLE IRA are:

  • Generally, employees who received at least $5,000 in compensation for the past two years
  • Employees who expect to receive the same amount in the current year

Once again, these are just guidelines and not set in stone. An employer can change these rules to be less restrictive but they can’t be adjusted to be more restrictive.

 

Contributions of Simple IRA

SIMPLE IRA plans allow for both employer and employee contributions. The money is typically deposited in a tax-deductible fashion and grows tax-deferred. However, any withdrawals are fully subject to ordinary income tax

There are two ways SIMPLE IRAs are funded: employer contributions and employee elective deferrals.

 

Employer Contributions

For employer contribution, employers have two options

  1. Match contributions for 3% of employee compensation
  2. Make non-elective contributions of 2% of compensation for all eligible employees, regardless of whether or not the employee contributes.

Non-elective contribution compensation is capped at $330,000 for 2023. This means for any employees earning $330,000 or more, the maximum employer contribution is $6,600.

Employers can choose a lower matching contribution below 3% but there are a few conditions that must be met.

  • Matching contributions can’t be reduced below 1%
  • Matching contributions can only be reduced for 2 years or less
  • You must notify employees within a reasonable time before the 60-day election period for employees.

 

Employee Contributions

As of 2023, employee contributions are limited to $15,500 per year. Employees over the age of 50 can contribute a $3,500 “catch-up” contribution for a total of $19,000.

Withdrawals of Simple IRA

Withdrawals from a SIMPLE IRA made before the age of 59 ½ may be subject to a 10% early withdrawal penalty. If the withdrawal occurs within the first two years of an employee’s participation in the plan, the early withdrawal penalty increases to 25%. As with other tax-deferred retirement plans, there is a required minimum distribution (RMD) that begins at age 72.

 

SIMPLE IRA Set-Up and Administration

One of the key benefits of Simple IRA accounts is that they are easy to set up and maintain once created. Here’s a three-step process to set up a SEP IRA:

  1. Draft and execute a written agreement to provide benefits to all eligible employees.
  2. Disclose to all employees certain information about the agreement.
  3. Set up a Simple IRA account for each eligible employee.

Employers generally have no filing requirements for SIMPLE IRA plans and don’t have to file a Form 550o return.

In addition, Simple IRA contributions are tax-deferred. Salary reduction or elective contributions are subject to social security, medicare, and federal unemployment taxes. On the other hand, matching and nonelective contributions aren’t subject to those taxes.

 

SEP IRA vs SIMPLE IRA

SEP IRASIMPLE IRAEdge
Number of employeesAny size business100 or fewer employeesSEP
Employee Eligibility (*employees also include self-employed individuals)Eligibility requirements set by the employer. Requirements can be made less restrictive but not more restrictive.

Some standard employee eligibility requirements are:


At least 21 years of age
Has worked for the employer in at least three of the last five
years;
And received at least $750 in 2023; $650 in 2021 and 2022; $600 in compensation (in 2016 – 2020)
Eligibility requirements set by the employer. Requirements can be made less restrictive but not more restrictive.

Some standard employee eligibility requirements are:


Employees who received at least $5,000 in compensation for the past two years and who expect to receive the same amount in the current year
Tie-

Both plans allow employers to adjust eligibility requirements according to their needs.

For example, an employer could adjust the minimum age requirement to 18 instead of 21 in a SEP.

Similarly, they could make the minimum earning in a SIMPLE to be $100 or $1.00 if they choose
Contribution ParticipationOnly employers can contributeBoth employee and employer can contributeSEP- With SEP, funds do not come out of employee paychecks. This feature can make a SEP-IRA attractive to small business owners who want to aid their employees in their retirement planning without requiring employees to make their own contributions.
Contribution LimitsAs of 2023, contributions are capped at 25% of total employee compensation or up to $66,000 per year, whichever is lower.

To contribute the maximum amount to a SEP IRA account, you must earn an annual salary of at least $264,000.
As of 2023, employee contributions are limited to $15,500 per year or $19,000 if the employee is over the age of 50.

Employers must choose one of two options:

1. Match contributions for 3% of employee compensation
2. Make non-elective contributions of 2% of compensation for all eligible employees
SEP- SEP plans have a higher contribution limit than Simple IRA
Flexibility ContributionsEmployers can choose any contribution percentage up to 25%, as long as it does not exceed the annual limit.There are two ways SIMPLE IRAs are funded: employer contributions and employee elective deferrals.


Employer contributions:

Employers must match contributions for 3% of employee compensation or make non-elective contributions of 2% for all eligible employees, regardless of whether or not the employee contributes.

Employee elective deferrals:

Employees can defer up to $15,500 as of 2023. For employees age 50 or over, a $3,500 “catch-up” contribution is also allowed
SIMPLE IRA – Both employers and employees can contribute
Vesting Period100% vested immediately100% vested immediatelyTie
Taxes on Contributions / DistributionsA SEP-IRA can either be a traditional or a Roth plan. The taxes on the contributions and distributions depend on which type you choose.

Traditional: Contributions are pre-tax and distributions are taxed.

Roth: Contributions are taxed and distributions are tax-free.
A SIMPLE IRA can either be a traditional or a Roth plan. The taxes on the contributions and distributions depend on which type you choose.

Traditional: Contributions are pre-tax and distributions are taxed.

Roth: Contributions are taxed and distributions are tax-free.
Tie – But Roth SIMPLE IRA was introduced in 2022 and may not be offered by many employers yet.
Backdoor RothIf you have pre-tax funds in a SEP IRA, this can make Backdoor Roth conversions more complicatedContributions and earnings can’t be rolled over until two years of participation and you will be taxed on any pre-tax earnings and contributions including the transferred amount. Tie – Both need to be done carefully ensuring that the rules are followed.
Start-up and operating costSimple to create and cost-effective to maintain.
Require little to no administration.

No reporting requirements for employers.
Simple to create and cost-effective to maintain.
Requires little to no administration.

No reporting requirements for employers.
Tie – Both are designed to be simple and cost-effective
Withdrawal RulesParticipants can begin taking penalty-free withdrawals at the age of 59.5, although they will be subject to income tax upon withdrawal.

Mandatory withdrawals, also known as Required Minimum Distributions (RMDs), begin at the age of 72.
Participants can begin taking penalty-free withdrawals at the age of 59.5, although they will be subject to income tax upon withdrawal.

Mandatory withdrawals, also known as Required Minimum Distributions (RMDs), begin at the age of 72.
Tie

 

SEP IRA vs SIMPLE IRA: Key Differences

SEP IRA vs SIMPLE IRA: Who Is Eligible?

A SEP IRA can be established by any business, including sole proprietorships, partnerships, and corporations.

SIMPLE IRAs are designed for businesses with 100 or fewer employees that do not maintain another retirement plan. Both the employer and employees must have earned income from the business to participate.

 

SEP IRA vs SIMPLE IRA: Contribution Participation

SEP IRAs only allow employer contributions. In addition, SEP IRA contributions are not mandatory and employers have full discretion.

SIMPLE IRAs allow both employer and employee contributions. These contributions are mandatory following one of the two contribution options for a simple IRA and employers can’t decide not to contribute.

 

SEP IRA vs SIMPLE IRA: Contribution Flexibility

SEP IRA contributions can be made at any time before you file your tax return’s due date, including an extension.

In contrast, SIMPLE IRA matching contributions must be made within 30 days of the employee’s paycheck in which the salary was deferred.  Employer contributions can be made up until the due date of the employer’s tax return.

As such, SEP IRAs arguably have greater contribution flexibility compared to SIMPLE IRAs.

 

SEP IRA vs SIMPLE IRA: Contribution Limits

SEP IRAs allow employers to contribute up to $66,000 (in 2023) or up to 25% of an employee’s salary, whichever is less. To contribute the maximum amount to a SEP IRA account, you must earn an annual salary of at least $264,000.

In contrast, SIMPLE IRAs have lower limits. Employees can contribute up to $15,500 (in 2023). For employees aged 50 or over, a $3,500 “catch-up” contribution is also allowed, which would allow for a total contribution of $19,000.

Furthermore, with SIMPLE IRAs, employers have two contribution options:

  1. Match contributions for 3% of employee compensation
  2. Make non-elective contributions of 2% of compensation for all eligible employees

To put this into perspective, let’s consider a $100,000 salary making a 5% contribution to their simple IRA. With option 1, the employer’s contribution would be $3,000, and with option 2, the employer’s contribution would be $2,000.

 

When Should an Employer Choose a SEP IRA Over a SIMPLE IRA?

The choice between a SEP IRA and a SIMPLE IRA depends on the employer’s goals, financial resources, and employee preferences.

A SEP IRA may be better suited for businesses with few employees and higher profit margins, while a SIMPLE IRA may be more appropriate for growing businesses where employees value the opportunity to contribute directly to their retirement savings.

As of 2023, SEP IRAs allow higher contribution limits at $66,000 per year compared to SIMPLE IRA’s $15,500. This is something to consider if you’d like the option to contribute as much as possible to the retirement plan.

When deciding between these two, it’s also important to note that SEP IRA contribution requirements are not dependent on employee salary or employee contributions.

As an employer, you set your standard contribution percentage and follow it. SIMPLE IRAs, on the other hand, take into account employee contributions and employee compensation.

Finally, it’s important to consider that with SEP IRA plans, there is no obligation for an employer to contribute, and the employer has full discretion in the amount. On the other hand, with a SIMPLE IRA plan, employers must follow the contribution guidelines they chose when creating the plan.

 

Frequently Asked Questions:

 

Can you contribute to both a SEP IRA and a SIMPLE IRA in the same year?

You cannot contribute to both a SEP IRA and a SIMPLE IRA in the same year for the same business. However, if you have earned income from multiple businesses, you may be able to contribute to a SEP IRA for one business and a SIMPLE IRA for another.

 

How do tax benefits compare between SEP IRAs and SIMPLE IRAs?

Both SEP IRAs and SIMPLE IRAs offer tax-deferred growth and deductible contributions for employers. However, they differ in tax treatment for employees. In a SEP IRA, only the employer’s contributions are tax-deductible. In a SIMPLE IRA, both employee and employer contributions are tax-deductible, but employees’ contributions are also subject to FICA (Social Security and Medicare) taxes.

 

Can I contribute to a Roth IRA in addition to a SEP IRA and SIMPLE IRA?

Yes, you can contribute to a Roth IRA in addition to a SEP IRA and SIMPLE IRA. First, any contributions to a SEP IRA don’t count towards your personal contribution limits since all contributions are from the employer. Second, you can contribute to a Roth IRA and Simple IRA but the total contribution to your Roth IRA will depend on your filing status and annual income.

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1 thought on “SEP IRA vs Simple IRA: Which Retirement Plan Is Right for You?”

  1. Do either of these accounts require a “safe harbor” type of exclusion to allow for higher contributions from the employer to his own retirement fund, or highly compensated employees to theirs?

    Reply

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