SEP vs. SIMPLE IRAs: Which is Right for Your Business?

For those of you who are self-employed or run a small business, know there are a few retirement plan options for you and your employees—including some that are easy to set up, fairly simple to maintain, and don’t require any IRS reporting. Two such options are Simplified Employee Pension (SEP) and Savings Incentive Match Plan for Employees (SIMPLE) individual retirement accounts (IRAs).

In this post, we’ll review each one and provide insight into which option is possibly best for you and your employees.

What are SEP & SIMPLE IRAs?

Both SEP and SIMPLE IRA accounts are tax-deferred retirement savings plans used to provide retirement benefits for business owners and their employees. The term “tax-deferred” means you fund the account with pre-tax dollars and pay taxes on any withdrawals.

Who is eligible to open a SEP or SIMPLE IRA?

Only those who operate as a sole proprietor or business owner, are in a partnership, or earn self-employment income by providing a service can open a SEP IRA—with this as the only requirement.

For anyone looking to open a SIMPLE IRA account, the same rules apply; however, you must also have 100 or fewer employees and cannot maintain any other employer-sponsored retirement plan.

Who is eligible to participate in a SEP or SIMPLE IRA plan?

For employees to participate in a SIMPLE plan, they must have earned at least $5,000 in any two preceding years and expect to earn $5,000 or more in the year they are eligible. However, employers do have the option to adjust these requirements so they are less restrictive.

While exceptions for SEP IRAs do exist, eligibility typically extends to employees who are over the age of 20, have worked three out of the last five years, and earn at least $650 in annual income.

SEP IRA and SIMPLE IRA contribution details

With SIMPLE IRAs, employees can defer up to $14,000 or 100% of compensation: whichever is less. Those aged 50 and older can defer an additional $3,000, which is referred to as the “catch-up limit.” Employees may also contribute to their plan beyond the age of 70½.

Employers are also required to make contributions to employee accounts in one of two ways: through dollar-for-dollar matching contributions up to 3% of each employee’s compensation or by making non-elective contributions for all employees—including those who do not make contributions—equating to 2% of each employee’s compensation.

SEP IRAs are funded entirely by the employer, who has the flexibility to determine when to make contributions and how much to contribute since there are no requirements in this regard. That said, when employers do decide to make a contribution, they can contribute up to 25% of the employee’s/owner’s compensation or up to $61,000 (2022): whichever is less. Unlike with SIMPLE IRAs, SEP IRAs have no catch-up contributions. All employees, as well as the business owner(s), must receive the same contribution as a percentage of salary. Employers must also continue to make employer contributions for any employee over age 70½ if similar contributions are provided for their younger counterparts.

For both SEP and SIMPLE IRAs, employees are immediately 100% vested and must begin taking distributions at age 72.

Other SIMPLE and SEP IRA considerations

If you’re considering a SIMPLE IRA, think about just how much you want your company to grow—because if you expand beyond 100 employees, you’ll need to transition to a different type of retirement account. You also must make specific contributions to employee accounts on an annual basis, even if your company has a bad year. Like traditional IRAs, borrowing money against the account is prohibited, and a 10% penalty may apply for withdrawals taken before age 59½. A “2-year rule” also applies with SIMPLE IRA withdrawals, meaning that—regardless of your age—if you withdraw the money before a two-year period beginning on the first day your employer deposits contributions, your early withdrawal fee may increase from 10% to 25%.

With regard to SEP IRAs, all eligible employees must be included; in other words, one cannot merely opt in to the plan. Since each employee must receive the same contribution as a percentage of salary, this may limit his or her ability to make large personal contributions. As with SIMPLE IRAs, borrowing money against the account is prohibited, and a 10% penalty may apply for withdrawals taken before age 59½.

Who is best suited for each IRA account?

A SIMPLE IRA is best designed for larger businesses with up to 100 employees, as it allows both the employer and employees to contribute and fund the plan. On the other hand, only the employer is allowed to contribute and fund a SEP IRA plan. As a result, these are ideal for self-employed individuals or small business owners with no or few employees.

A SIMPLE IRA is also perhaps best suited for businesses with steady profits that want to allow pre-tax employee contributions—akin to 401(k) plans. For businesses with fluctuating income and/or those seeking additional flexibility, a SEP IRA is sometimes preferred since the employer has the authority to determine when to make contributions and how much money to contribute.

How to set up a SIMPLE or SEP IRA

Setting up either account is fairly simple—especially compared to other types of retirement plans! Essentially, those interested need only contact a retirement plan or investment professional to establish the plan and draft all related details, share a copy of plan documents with employees, and finally set up a SEP IRA account for each one.

SIMPLE IRAs must be established by October 1st if setting up for the current tax year, while SEP IRAs must be set up and funded by one’s tax filing deadline or extension.

In sum: SIMPLE vs SEP IRAs

Thankfully, choosing which plan to go with is fairly straightforward depending on your own unique circumstances. Generally speaking, if you have a small business (or are self-employed) with zero or few employees and want the flexibility to choose when and how much to contribute—especially if you have a seasonal business or fluctuating income—a SEP IRA is perhaps better for your needs.

For those with larger businesses (from several up to 100 employees), a SIMPLE IRA is likely a better option from an employer perspective since employees bear much of the funding burden. Employees can fund as much as they want (up to the contribution limits) and receive a company match, much like how a 401(k) plan works.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and not intended to provide specific advice or recommendations for any individual or business.