SEP vs. SIMPLE IRA for Sole Proprietors & Small Business Owners

One of the benefits that a startup or a small business can offer its employees, or potential employees, is a retirement savings plan. Employers can deduct employer contributions on from income taxes and employees can contribute pre-tax and experience tax-deferred growth until retirement.

Two types of retirement savings plans that are most suited to small business owners are a SEP IRA and a SIMPLE IRA. “SEP” stands for Simplified Employee Pension, while “SIMPLE” stands for Savings Incentive Match Plan for Employees. SEP IRAs and SIMPLE IRAs differ from one another in several ways.

Differences Between SEP and SIMPLE IRA

	SEP IRA	SIMPLE IRA
Employer eligibility	Can not have any other retirement savings plan in place; available to any size business	Must have no other retirement savings plan in place; must have less than 100 employees
Employee eligibility	Must be at least age 21, have worked for the employer a minimum of 3 of the last 5 years, and have received at least $650 in compensation for 2021 and 2022	Earned a minimum of $5,000 during any two years prior to the current year and expects to earn the same this year; cannot opt out of participating in the plan but they can choose not to contribute
Company size	Can be set up by any size business	Can only be set up by those with fewer than 100 employees
Employer contribution limits	Up to 25% of an employee’s salary, or $61,000, whichever is less; Must contribute an equal percentage for all employees	Mandatory and must be either a dollar-for-dollar matching contribution to that of the employee of up to 3% or a non-elective contribution of 2% of an employee’s annual salary up to a salary limit of $305,000
Employee contribution limits	None since only employers can contribute	Limit of $14,000 for those under age 50 & $17,000 for those over age 50; contributions are automatically deducted from paychecks and grow tax-deferred until retirement
Cost to Manage	Financial institutions, such as Schwab, don’t charge to open or maintain these accounts but may charge “account fees, fund expenses, and brokerage commissions”	Financial institutions don’t charge a setup fee but do charge a low annual maintenance fee ($10–$25 per participant), or a yearly fee per participant; May also charge a fee when an account is closed or a balance is transferred
Annual IRS reporting	No annual reporting	No annual reporting
Employee vesting	Immediately 100% vested and have full control of the money in their account	Contributions are 100% vested and employees have full control of the money in their account
Distributions	Taxed only upon distribution, with money withdrawn before age 59.5 incurring a 10% bonus penalty; distributions are mandatory at age 72	Taxed only upon distribution, with money withdrawn before age 59.5 incurring a 10% bonus penalty; distributions are mandatory at age 72
Accounts’ location	Employer decides where to set up the accounts, but employees can make their own investment decisions	Employer fills out either IRS Form 5304-SIMPLE to allow employees to decide where the accounts will be held, or the employer fills out IRS Form 5305-SIMPLE to specify location

Eligibility Requirements

While an employer of any size can set up a SEP IRA plan, only employers having fewer than 100 employees can set up a SIMPLE IRA plan. However, employers who have a SIMPLE IRA plan in place but who cross the threshold of 100 employees may continue with the plan for two additional years. This favors fast-growing start-ups.

Employer Contribution Limits

The high threshold of employer contributions to SEP IRAs, which in 2022 is up to 25% of an employee’s salary, or $61,000, whichever is less, can be a powerful inducement for attracting potential employees and keeping current ones. It is also a way for employers to reward their key employees.

For an employer who opted for the 2% of an employee’s annual salary up to a salary limit of $305,000 for their SIMPLE IRA plan, the maximum they can contribute is $6,100 (2% of $305,000), exactly one-tenth of the SEP IRA’s limit.

Tax Implications

Both SEP-IRAs and SIMPLE IRAs are deferred tax accounts that are funded with pre-tax dollars and result in a reduction of taxable income. However, once money from either type of account is withdrawn at retirement, it is taxed at the account holder’s ordinary rate of income tax.

For employees, if they feel that their tax bracket will be lower once they retire, a SEP IRA and a SIMPLE IRA make sense, but for those who expect their tax bracket to rise, up to and into retirement, a Roth IRA may make more sense since it is funded with after-tax dollars and withdrawals during retirement are tax-free.

Pros & Cons of a SEP IRA

Pros:

• Tax advantages: allows employees including the self-employed to make contributions with pre-tax dollars, providing a tax reduction, and taxes are only paid on withdrawals.
• Easy setup: SEP IRAs can be set up with banks, insurance companies, or other qualified financial institutions, and require an employer to fill out only IRS Form 5305-SEP.
• Immediate vesting: employees are immediately vested, meaning they have immediate access to any employer-contributed funds; this might be a bad thing if an employer wants an impetus for employees to stay.
• Larger contribution limits: contribution limits are higher than a Traditional IRA, a Roth IRA, a 401k, or a SIMPLE IRA.
• Flexibility: employers don’t have to make a contribution every year, either for themselves or for their employees.
• Rollovers: the rules for rolling over or transferring funds are the same as those of a traditional IRA, funds can be moved to or from a SEP IRA into or from a traditional IRA or another pre-tax retirement plan such as a 401k or 403b without incurring taxes or penalties.

Cons:

• No catch-up contributions: there are no catch-up contributions available for those ages 50 or over, however, that might be offset by the SEP IRA’s higher contribution limits.
• No Roth option: contributions can’t be made with after-tax dollars thus making withdrawals tax-free.
• Early withdrawal penalties: early withdrawals made by those under age 59.5 result in a 10% penalty on top of any applicable taxes.
• Required withdrawals: withdrawals have to start at age 72.

Pros & Cons of a SIMPLE IRA

Pros:

• Automatic deductions: employee contributions are automatically deducted from their paychecks and qualify as elective deferrals.
• Reduce taxable income: contributions are tax-deferred, reducing an employee’s taxable income for the year, and investment growth is tax-deferred until distributions start.
• Easy setup: SIMPLE IRAs are set up through banks, savings and loan associations, insurance companies, certain regulated investment companies, federally insured credit unions, and brokerage companies, and investment options include stocks and bonds as well as mutual funds.
• Immediate vesting: employees are immediately vested, providing them access to funds contributed by the employer.
• Larger contribution limits: contribution limits are higher than those of a Traditional IRA or a Roth IRA, but not more than a 401k or a SEP IRA.
• Catch-up contributions: employees age 50 or older can save an additional $3,000 a year as a catch-up contribution.
• Employer tax deduction: employers receive a tax deduction for their contributions to employees’ accounts.
• Employee non-participation: for employers who choose the 3% option, if an employee doesn’t contribute, the employer doesn’t have to contribute either, and employers can reduce the 3% contribution to a minimum of 1%, but for no more than two out of five years.
• Employee exclusions: employers can exclude employees receiving retirement benefits through their union, and nonresident alien employees who do receive U.S. wages, salaries, or other personal services compensation from the employer can also be excluded.
• Rollovers: funds in a SIMPLE IRA can be rolled over into another employer’s SIMPLE IRA plan, and as of December 2015, SIMPLE IRA accounts are permitted to accept transfers from SEP IRAs, Traditional IRAs, and employer-sponsored plans, such as 401k plans.
• Other plan contributions: the IRS allows employees to contribute to other retirement savings plans, such as Traditional IRAs or Roth IRAs, at the same time they are contributing to a SIMPLE IRA plan.
• Annual election period: employees are allowed to change their contribution levels each year during the SIMPLE IRA plan’s election period which must be at least 60 days long.
• Termination: employees can terminate their contributions to a SIMPLE IRA plan at any time.
• More investment choices: SIMPLE IRAs offer a greater number of investment choices than those offered by 401k plans which are primarily limited to mutual funds.

Cons:

• Lack of employer contribution: employers who have chosen the 3% option aren’t required to make a contribution if an employee chooses not to make any contributions.
• Lower contribution limits: SIMPLE IRA contribution limits are lower than other workplace retirement plans, with a limit in 2022 for those under age 50 of $14,000 per year versus $20,500 for a 401k plan, and for those 50 or older of $17,000 versus $27,000 for a 401k plan.
• Limited rollovers: a SIMPLE IRA cannot be rolled over into a Traditional IRA without a waiting period of two years from the date on which the employee first participated in the plan.
• Early withdrawal penalties: for those less than 59.5-years-old, and who have participated in the plan for less than two years, an early withdrawal comes with a 15% early withdrawal penalty on top of the 10% penalty, resulting in 25% of a SIMPLE IRA account’s balance being paid to the IRS plus income taxes will have to be paid on the money.
• Income taxes: any amount withdrawn from a SIMPLE IRA and not rolled over, regardless of age, is subject to ordinary income tax for the year in which the distribution is made.
• No Roth versions: a SIMPLE IRA has no versions of a Roth IRA or a Roth 401k, which means a SIMPLE IRA account can’t be funded with post-tax dollars and withdrawals can’t be tax-free.
• No loans permitted: loans from a SIMPLE IRA are not permitted, and the assets may not be used as collateral.

Who Is a SEP IRA Best For?

A SEP IRA is best for best for the self-employed and small business owners who want to reward their key employees. A SEP IRA’s contribution limit is higher than that of a Traditional IRA, a Roth IRA, a SIMPLE IRA, and a 401k, and employers don’t have to make a contribution every year which benefits startups and companies experiencing volatility in their cash flows.

Who Is a SIMPLE IRA Best For?

A SIMPLE IRA is best suited to small businesses with fewer than 100 employees because employee contributions are automatically deducted from their paychecks. It can also benefit employees who do not contribute to their own retirement savings accounts because if their employer has chosen the 2% non-elective contribution method, they will still receive some retirement savings.

SIMPLE or SEP IRA vs. 401k

The costs of setting up and managing a 401k plan are greater than those of either a SIMPLE IRA or a SEP IRA plan. A 401k plan initially costs between $500 and $2,000 and, if a third-party administrator is hired, they may charge a per-participant fee of between $15 and $60 per year per participant. Additionally, employers must create a 401k plan document, select investment vehicles, send employees required participant disclosures, approve and administer loans against retirement accounts, approve distributions and rollovers, and provide to the IRS data used in annual compliance testing to ensure more highly paid employees are not being favored.

Bottom Line

Both a SEP IRA plan and a SIMPLE IRA plan are easier to set up and far less costly to administer than a 401k plan. A retirement savings plan can be a powerful lure to potential employees, and be an inducement for existing employees to remain with a company. Both plans, and especially the SEP IRA, allow the self-employed to meaningfully save for their retirement.