Understanding Retirement Options for Your Small Business: SEP IRA vs. SIMPLE IRA
As your small business grows, it’s time to start thinking about the kinds of financial benefits you’d like to offer your employees. While you want to offer your employees the safety and security of a retirement plan, it can be difficult to understand what you can afford and what options require the least amount of work, maintenance, and expense.
But it doesn’t have to be complicated.
We broke down the two main plans, SEP and SIMPLE IRAs, to explain the advantages, who qualifies, and provide examples. Some of the main differences to consider when choosing a plan are how many people your company employs, contribution limits and whether employees contribute (SEP IRA plans only allow the employer to make contributions to the account whereas a SIMPLE IRA allows more employee control).
[Related post: Differences between a Roth and Traditional IRA]
SEP – Simplified Employee Pension
Summary: A Simplified Employee Pension (SEP or SEP IRA) is designed for self-employed individuals or small businesses with fewer than 25 employees. If you earn a self-employment income, you are allowed to save more for retirement using a SEP plan than a traditional IRA or Roth allows.
Who is a SEP good for?
Self-employed people or small businesses with fewer than 25 employees. The SEP allows for pre-tax contributions toward retirement without getting involved in a more complex qualified plan such as a 401(k). Contributions to a SEP are tax-deductible and compound tax-deferred until withdrawn, pending that the distribution is taken after the account holder reaches 59 1/2 years of age. Additional information related to SEP accounts can be found on the IRS website.
- Less complex and costly than a 401(k)
- Allows individuals to contribute larger amounts than a traditional or Roth IRA
- May qualify for larger tax deductions
Who can and cannot participate in a SEP
The IRS tells us who can participate in a SEP. The employee:
- Has reached age 21
- Has worked for the employer in at least three of the last five years
- Received at least $600 in compensation from the employer during the year (for 2019 and 2020)
An employer can use less-restrictive participation requirements than those listed, but not more restrictive ones.
Who can’t participate in a SEP:
- Employees covered by a union agreement and whose retirement benefits were bargained for in good faith by the employees’ union and the employer.
- Nonresident alien employees who do not have U.S. wages, salaries or other personal services compensation from the employer.
SEP contribution limits
The IRS states that employers’ contributions cannot exceed the lesser of:
- 25% of the employee’s compensation, or
- $57,000 for 2020 ($56,000 for 2019)
Here are examples from the IRS to help demonstrate when a SEP is a good choice:
Example 1: Employer X maintains a calendar year SEP. The eligibility requirements under the SEP are: An employee must perform service in at least three of the immediately preceding five years, reach age 21 and earn the minimum amount of compensation during the current year. Bob worked for Employer X during his summer breaks from school in 2016, 2017 and 2018, but never more than 34 days in any year. In July 2019, Bob turned 21. In August 2019, Bob began working for Employer X on a full-time basis, earning $30,000 in 2019. Bob is an eligible employee in 2019 because he has met the minimum age requirement, has worked for Employer X in three of the five preceding years and has met the minimum compensation requirement for 2019.
Example 2: Employer Y writes its SEP plan to provide for immediate participation regardless of age, service or compensation. John is age 18 and began working part-time for Employer Y in 2019. John is an eligible employee for 2019.
SIMPLE IRA plan
Summary: Savings Incentive Match Plan for Employees allows employees and employers to contribute to traditional IRAs set up for employees.
Who is a SIMPLE plan good for?
It is ideally suited as a start-up retirement savings plan for small employers (100 or fewer employees) not currently sponsoring a retirement plan. With a SIMPLE plan, contributions are tax-deductible, and earnings within the account are tax-free until withdrawn. Employees are also 100% vested, which means they are able to take all funds, including employer contributions, with them if they leave.
- Flexibility for employers to choose to match employee contributions or the employer can contribute a fixed percentage of eligible employees’ pay
- Ease for the employer: A SIMPLE IRA is simple to set up and maintenance is typically more affordable than other options and there are generally no filing requirements with the IRS
- Tax-deductible contributions as well as tax benefits when employees withdraw from the account in retirement
Who can and cannot participate in a SIMPLE?
You can establish a SIMPLE IRA plan if you meet BOTH of the following requirements:
- You meet the employee limit
- You do not maintain another qualified plan, unless the other plan is for collective bargaining employees
You can establish a SIMPLE IRA plan only if you had 100 or fewer employees who received $5,000 or more in compensation from you for the preceding year.
Under this rule, you must take into account all employees who were employed at any time during the calendar year, regardless of whether they’re eligible to participate.
The SIMPLE IRA plan generally must be the only retirement plan to which you make contributions, or to which benefits accrue, for service in any year beginning with the year in which the SIMPLE IRA plan becomes effective.
SIMPLE IRA contribution limits
A SIMPLE IRA allows:
- Employee contributions in 2019 of up to $13,000 if you are under age 50, and a catch-up contribution of up to $16,000 if you are 50 or older.
- Employee contributions in 2020 of up to $13,500 if you are under age 50, and a catch-up contribution of up to $16,500 if you are 50 or older.
Employers are generally required to match each employee’s salary reduction contributions, on a dollar-for-dollar basis, up to 3 percent of the employee’s compensation. You can deduct SIMPLE IRA contributions for the tax year within which the contributions were made.
Another option: The Solo 401(k)
If you are the sole proprietor of your business, you and your spouse may qualify for the Solo 401(k) option, which combines elements of the SEP and SIMPLE plans.
This option offers higher contribution amounts and possible tax deductions. However, there are precise qualifications that must be met in order to be eligible. Learn more about the Solo 401(k) and see if you qualify.
For more information about the difference between these plans, Equity Trust National Education Specialist John Bowens simplifies what you need to know in this whiteboard session:
Equity Trust holds a variety of IRAs, as well as other self-directed accounts, including:
- Traditional IRA
- Roth IRA
- Simple IRA
- SEP IRA
- Solo 401(k)
- Roth Solo 401(k)
- Health Savings Account (HSA)
- Coverdell Education Savings Account (CESA)
A self-directed IRA is a retirement account that allows for investments in alternative assets such as real estate, promissory notes, and precious metals, in addition to stocks and mutual funds. The account owner determines how they would like to manage their account and directs the custodian to process the transactions within the account. In addition to Traditional and Roth IRAs, other accounts such as SEPs, SIMPLEs, Solo 401(k)s, health savings accounts, and Coverdell education savings accounts can be self-directed as well.
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