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Business owners and the self-employed have more than one way to set up a retirement account for themselves and their employees. Two of the most popular are the SEP IRA and the SIMPLE IRA, both of which offer many of the major tax advantages of a regular IRA. These plans also offer business owners a way to avoid the administrative hassle of typical retirement plans such as the 401(k).
While they share the IRA badge with their more well-known cousins, the SEP IRA and SIMPLE IRA are not for individuals to establish but rather for businesses, including sole proprietorships. (If you’re an individual looking to set up a traditional IRA or Roth IRA, then you’ll want to look at the benefits of those plans.)
Here’s how the SEP IRA compares to the SIMPLE IRA and the key factors you should consider when deciding between the two plans.
What is a SEP IRA?
SEP stands for Simplified Employee Pension, and this plan is available for employers, including the self-employed. Employers can avoid the complex reporting requirements that the government usually mandates for retirement plans.
With a SEP IRA, only the employer makes contributions to the account. Employers may contribute up to 25 percent of an employee’s pay annually to the account, up to a total contribution of $66,000 for 2023. The employer must contribute an equal percentage for all employees, though it may exclude some who have retirement plans through a union agreement.
The employee is immediately 100 percent vested in all SEP IRA contributions and has full control of the money. With a traditional SEP IRA, employees can enjoy tax-deferred growth until retirement on any deposits, or they can choose a Roth SEP IRA and enjoy tax-free growth.
In terms of distributions, a traditional SEP IRA functions like a traditional IRA, and money is taxed only when it’s withdrawn. If you withdraw money from the account before age 59 ½, you’ll typically be assessed a bonus penalty of 10 percent. And you’ll need to take required minimum distributions on the account following the rules laid out by the IRS, which mandate distributions start by at least age 73.
If you opt for the Roth SEP IRA, your money grows tax-free and you can withdraw it tax-free at age 59 ½. You can take out contributions at any point without tax or penalty – though not earnings – and the account has no required minimum distribution. The Roth SEP IRA was created in 2023, as part of the SECURE Act 2.0.
What is a SIMPLE IRA?
SIMPLE stands for Savings Incentive Match Plan for Employees, and it’s available for employers (including the self-employed) with no more than 100 employees earning more than $5,000 in the preceding year. Employers can skip the complex federal reporting requirements that are typical of a 401(k), and they can hire a financial institution to administer the program.
With a SIMPLE IRA, employees can have contributions deducted from their paycheck and deposited into their account, where they can grow tax-deferred until retirement.
The plan allows employees to contribute up to $15,500 in 2023, while those age 50 and over can add an additional $3,500 (in 2023). These elective deferrals count toward the annual maximum on elective deferrals for this and other retirement programs.
Employers must contribute to their employees’ SIMPLE IRA, and they have two options:
- Match employees’ contributions dollar for dollar, up to 3 percent of individual earnings.
- Contribute 2 percent of employees’ wages up to the annual compensation limit of $330,000 for 2023.
With a SIMPLE IRA, employees can enjoy tax-deferred growth until retirement on any deposits in a traditional account, or they can choose a Roth SIMPLE IRA and enjoy tax-free growth.
When it comes to distributions, a traditional SIMPLE IRA works like a traditional IRA. Money is taxed only when it’s withdrawn. If you withdraw the funds before age 59 ½ or under some special exceptions, the IRS may sock you with a 10 percent bonus penalty and a 25 percent levy in certain circumstances. You’ll also have to take required minimum distributions starting at age 73 under the IRS’s rules.
If you opt for the Roth SIMPLE IRA, your money grows tax-free and you can withdraw it tax-free at age 59 ½. You can take out contributions at any point without tax or penalty – though not earnings – and there’s no required minimum distribution. The Roth SIMPLE IRA was created in 2023, as part of the SECURE Act 2.0.
Pros and cons of a SEP IRA
Advantages of a SEP IRA
- Provides a way for you (and employees) to save for retirement: If you’re self-employed, you might not have many options for tax-advantaged retirement savings, and this plan can help.
- Tax-deferred or tax-free: Your contributions can be made with pre-tax or after-tax dollars. So you can choose to receive a tax deduction today and only pay taxes when you withdraw the money or opt for the Roth version and enjoy tax-free withdrawals.
- Easy to set up: A broker offering SEP IRAs can guide you through a few simple steps after you fill out one IRS form.
- Immediate vesting: Employees enjoy immediate vesting on any employer contribution, so the money is legally theirs as soon as it’s deposited.
- Make larger contributions: Contribution limits are higher than traditional and Roth IRAs, as well as more than what you can contribute to a 401(k).
- Flexibility: You don’t have to make a contribution every year, for yourself or your employees.
Disadvantages of a SEP IRA
- The plan must treat employees the same as you: A SEP IRA is an employer-only contribution. Employees don’t make their own contributions and you must contribute the same percentage of employee compensation as you do to your own account.
- No catch-up contributions: If you’re age 50 or over, there are no catch-up contributions as there are with IRAs and 401(k)s. However, the higher contribution limits of a SEP IRA might outweigh this negative.
- Penalties for early withdrawal: Like a traditional IRA, if you withdraw your money from a traditional SEP IRA before age 59 ½, you’ll be hit with taxes and a 10 percent bonus penalty. If you’re using a Roth SEP IRA, you can withdraw contributions at any time without tax or penalty, though any earnings are subject to a penalty if they’re withdrawn before 59 ½.
- Required minimum distributions: You have to withdraw a minimum amount from the traditional SEP IRA annually starting at age 73, though the Roth version has no required minimum withdrawal.
Pros and cons of a SIMPLE IRA
Advantages of a SIMPLE IRA
- Provides a way for you (and employees) to save for retirement: If you’re self-employed, the plan gives you a way to save more in a tax-advantaged account.
- Tax-deferred or tax-free growth: Any contributions can grow tax-deferred in the traditional SIMPLE IRA until they’re withdrawn or tax-free in the Roth SIMPLE IRA.
- Paycheck deductions: Employees can have their contributions deducted from their paycheck, as they would in typical 401(k) plans.
- Two ways to contribute to plans: Employers can contribute to employees in two ways: match contributions dollar for dollar up to 3 percent of earnings or make non-elective contributions up to 2 percent of an employees’ salary up to the annual compensation limit.
- Immediate vesting: Employees enjoy immediate vesting on any employer match, so the money is legally theirs as soon as it’s deposited.
- Larger contributions: Contribution limits are higher than for traditional and Roth IRAs, though not more than for a 401(k) or SEP IRA.
- Catch-up contributions: Employees age 50 or older can save an additional $3,500 (in 2023) as a catch-up contribution.
Disadvantages of a SIMPLE IRA
- Limited to smaller companies: Employers must have no more than 100 employees earning more than $5,000 in the preceding year to create a SIMPLE IRA.
- Employers must fund accounts: Employers are required to fund their employees’ accounts each year.
- Penalties for early withdrawal: If you withdraw money from a traditional SIMPLE IRA before age 59 ½, you’ll be hit with taxes and a 10 percent bonus penalty. In a Roth SIMPLE IRA, you can withdraw contributions at any time without tax or penalty, though any earnings withdrawn before age 59 ½ will have a penalty.
- Required minimum distributions: You have to withdraw a minimum amount annually from the traditional SIMPLE IRA starting at age 73. The Roth version has no required minimum distribution.
Contribution limits for SEP IRAs and SIMPLE IRAs
|Contribution limit (2023)
|$15,500 (plus $3,500 for those over age 50)
Key differences between SEP IRAs and SIMPLE IRAs
While the SEP IRA and SIMPLE IRA look a lot like 401(k) programs, they differ in important respects from that as well as from each other. Both programs are set up by employers on behalf of their employees and have similar distribution rules as a traditional or Roth IRA.
Key differences between the two programs include the following:
- The SEP IRA allows only employers to contribute to the plan, and employees are not allowed to add money.
- The SIMPLE IRA allows employees to add money using elective deferrals from their paycheck, so they can control how much they want to save.
- With the SIMPLE IRA employers must contribute some amount to their employees’ accounts or risk running afoul of the IRS. They have two choices for contributing.
- With a SEP IRA, employers may contribute to the plan, but they are not obligated.
- A SEP IRA allows employers to contribute up to $66,000 (in 2023), or up to 25 percent of an employee’s salary, whichever is less. In contrast, a SIMPLE IRA allows employees to contribute up to $15,500 (in 2023), while employers can add additional contributions.
Both plans are popular with small businesses, especially those who are self-employed, because of the plans’ ability to stash away huge amounts of money above and beyond what they can do in their own personal IRA. Another popular choice for the self-employed is the solo 401(k).
The SEP IRA and SIMPLE IRA were created to help smaller employers, including the self-employed, have a more robust vehicle to help employees save for retirement. The plans boast large maximum contributions and offer varying benefits, but it’s up to employers to decide which plan works best for them and their financial situation. Finally, the self-employed might consider another retirement plan, the solo 401(k), which offers various other benefits.