SEP IRA vs. SIMPLE IRA: How to Choose

For small business owners and self-employed individuals, specialized retirement plans offer a way to build a nest egg while gaining tax advantages. Understanding the differences between prominent options like the Simplified Employee Pension (SEP) IRA and the Savings Incentive Match Plan for Employees (SIMPLE) IRA is the first step in choosing the right plan.

Understanding the SEP IRA

A Simplified Employee Pension (SEP) IRA is a retirement plan well-suited for self-employed individuals and small businesses with few or no employees. The plan is funded exclusively by employer contributions, which simplifies administration since employees cannot contribute. The setup process involves a written agreement, like IRS Form 5305-SEP, and ensuring each eligible employee establishes a traditional IRA to receive the funds.

Contribution amounts to a SEP IRA are flexible, which is advantageous for businesses with fluctuating income. An employer is not required to make contributions every year. When contributions are made, they must be uniform for all eligible employees, including the owner, based on a percentage of compensation. For example, if the owner contributes 10% of their compensation, they must also contribute 10% for every eligible employee.

The contribution limits for a SEP IRA are substantial. An employer can contribute up to 25% of an employee’s compensation, with a maximum contribution of $69,000 for 2024 and $70,000 for 2025. An employee is eligible to participate if they are at least 21 years old, have worked for the business in three of the last five years, and have earned at least $750 in compensation for the year. The deadline to establish and fund a SEP IRA for a tax year is the business’s tax filing deadline, including any extensions.

Understanding the SIMPLE IRA

A Savings Incentive Match Plan for Employees (SIMPLE) IRA is designed for small businesses with 100 or fewer employees. This plan allows both employees and the employer to make contributions, making it an attractive option for businesses that want to encourage employee participation. An employer who offers a SIMPLE IRA cannot offer any other employer-sponsored retirement plan.

Employee contributions are made through pre-tax salary deferrals. For 2024, employees can contribute up to $16,000, and this amount increases to $16,500 for 2025. Individuals aged 50 and over can make additional catch-up contributions; for 2025, the catch-up amount is $3,500, with a higher limit of $5,250 for those aged 60 to 63. These contributions are always 100% vested, meaning the employee has immediate ownership of the funds.

Employer contributions to a SIMPLE IRA are mandatory each year, and the business has two choices. The first option is a dollar-for-dollar match of employee contributions, up to 3% of the employee’s compensation. The second is a non-elective contribution of 2% of each eligible employee’s compensation, regardless of whether they contribute. An employee is eligible if they earned at least $5,000 in any two previous years and are expected to earn that much in the current year.

Key Differences and Choosing a Plan

A primary distinction between the plans is contribution flexibility. SEP IRA contributions are at the employer’s discretion each year, offering adaptability for businesses with variable profits. In contrast, SIMPLE IRAs require a mandatory employer contribution annually, providing a predictable but less flexible cost for the business.

The source and limits of contributions also differ. A SEP IRA is funded only by the employer, with much higher annual contribution limits, making it a powerful tool for owners who want to maximize their own savings. A SIMPLE IRA allows for both employee and employer contributions, but the combined total is lower than what is possible with a SEP IRA.

From an administrative standpoint, both plans are less burdensome than a 401(k), as neither requires annual IRS reporting through forms like the Form 5500. The SEP IRA is often simpler because it only involves employer contributions. The SIMPLE IRA adds a layer of complexity by requiring the tracking of employee salary deferrals and executing the mandatory employer contribution.

A SEP IRA is often the best option for a sole proprietor or a business with few or no employees, especially when the owner wants to contribute a large amount and profits are inconsistent. A SIMPLE IRA is a better fit for a small business with a steady employee base that wants to offer a retirement benefit to attract and retain talent. It provides predictable employer costs and a way for employees to actively save for their own future.