Two popular self-employed retirement plans allowed by the Internal Revenue Service (IRS) include the SEP IRA and the SIMPLE IRA. With both plans, the employer can contribute—and in fact is obliged to contribute—funds toward their employee’s retirement, including (but not limited to) the owner’s.
So, how does a SEP IRA differ from a SIMPLE IRA, and which one makes the most sense for a small-business owner?
What is a SEP IRA and how does it work?
A simplified employee pension (SEP) plan is a retirement savings vehicle designed for small businesses of any size—from a sole proprietor with no employees to a company that employs 50 others. Even though it’s employer-sponsored, this plan is still an individual retirement account (IRA), and it follows the same distribution rules in retirement that traditional and Roth IRAs do. The contribution limit is higher, though.
Only employers can contribute to SEP IRAs; employees are not allowed to make elective deferrals to the account. Employers can contribute up to 25% of the employee’s compensation for the year, though contributions are limited to the lesser of that number or the 2022 annual limit of $61,000.
If an employer contributes to one SEP IRA (including the owner’s), they are required to make equal contributions to all eligible employees’ IRAs. Employees are immediately and wholly vested in these funds, and can choose how to invest them according to their own retirement savings preferences.
Taxes are not due on SEP IRA contributions or any investment gains until retirement. Once the account holder reaches age 59 ½, they can begin withdrawing funds from the account without penalty. Before age 59 ½, a 10% penalty tax may be incurred.
These funds are counted as ordinary income for the tax year in which they are withdrawn. As with traditional IRAs, SEP IRA plans have required minimum distributions beginning at age 72.
Loans are not allowed from SEP IRA plans, though there are some specific instances where early withdrawals are allowed without penalty.
What is a SIMPLE IRA and how does it work?
A Savings Incentive Match Plan for Employees, or SIMPLE IRA, is a retirement savings account for self-employed individuals as well as business owners with 100 employees or less. SIMPLE retirement plans require employers to contribute to the account on behalf of eligible employees. This requirement can fall into either of two categories, at the employer’s discretion:
- A 2% nonelective contribution. Regardless of the employee’s own contributions, the employer contributes 2% of their compensation for the year.
- A 3% matching contribution. The employer contributes a matching, dollar-for-dollar contribution based on the employee’s own contributions, up to 3% of the employee’s total compensation for the year.
To be eligible for a SIMPLE plan, an employee must earn at least $5,000 in compensation during the current year and in at least two preceding years.
In addition to required SIMPLE IRA employer contributions, employees can also make elective salary deferrals. For the employee, SIMPLE IRA contribution limits are up to $14,000 in 2022. For employees 50 or older, a catch-up contribution of $3,000 is allowed, bringing the total maximum to $17,000.
As with SEP plans, employees are automatically 100% vested in their SIMPLE IRA funds and are in control of the investment decisions within this account. Funds will grow tax-deferred until retirement (age 59 ½), when they can be withdrawn without penalty and counted toward the retiree’s ordinary income for that tax year.
If withdrawn prior to age 59 ½, a penalty tax of 10% may be incurred. If that withdrawal occurs prior to age 59 ½ and also within the first two years of account participation, the penalty tax increases to 25%. At age 72, required minimum distributions also kick in.
Loans are also not allowed from SIMPLE IRA plans, though there are some exceptions to the early withdrawal penalty.
What are the key differences between a SEP IRA and Simple IRA?
While SEP IRAs and SIMPLE IRAs are quite similar, there are some very important differences to note.
- Available to businesses of any size.
- Only employers can make contributions to employee SEP IRA plans; employees cannot make their own contributions.
- No compensation threshold required.
- Annual contribution limit of $61,000.
- No catch-up contributions allowed.
- Employer contributions are tax-deductible for the business, and the employee does not owe taxes on the funds until they withdraw them in retirement.
- Only available to businesses with 100 employees or less.
- Employer contributions are required, but employee contributions are also allowed.
- Employees must earn $5,000+ in compensation in the current year and in at least two preceding years to participate.
- Annual employee contribution limit of $14,000.
- Annual employer contribution limit of up to 3% of the employee’s compensation.
- Catch-up contribution of $3,000 is allowed for employees age 50+.
- Employer contributions are tax-deductible for the business, and the employee does not owe income tax on the funds until they withdraw them in retirement.
- Elective deferrals by the employee are tax-deferred—meaning they lower the employee’s taxable income in the year they contribute.
The bottom line
There are many similarities between SIMPLE IRAs and SEP IRAs. Both are popular options for self-employed individuals, as well as small-business owners looking to offer retirement savings as an employee benefit.
Both plans have higher contribution limits than those offered by other types of IRAs, without the complexity and cost of maintaining a company-sponsored 401(k).