SEP IRA vs. SIMPLE IRA: Key Differences

For small business owners and self-employed individuals, establishing a retirement savings plan is a foundational step toward long-term financial security. These plans provide a tax-advantaged way to save for the future and serve as a tool for attracting and retaining employees. Among the options, the Simplified Employee Pension (SEP) IRA and the Savings Incentive Match Plan for Employees (SIMPLE) IRA are two common choices. Each plan has a unique set of rules governing eligibility, funding, and administration, and understanding these differences is key to selecting the right one for your business.

Eligibility Requirements

A primary distinction between the two plans lies in which employers can establish them. A SEP IRA is available to a business of any size, from a self-employed individual to a large corporation. This flexibility makes it an accessible option for a wide range of business structures without a cap on the number of employees.

The SIMPLE IRA, however, is specifically designed for smaller businesses. An employer is only eligible to establish a SIMPLE IRA if they have 100 or fewer employees. This count includes only those employees who earned at least $5,000 in compensation during the preceding calendar year.

Employee participation rules also differ significantly. For a SEP IRA, an employee must be included if they are at least 21 years old, have worked for the employer in at least three of the last five years, and have earned at least $750 in compensation for the year. Employers can choose less restrictive criteria but cannot make them more stringent.

In contrast, the eligibility requirements for a SIMPLE IRA are based on earnings. An employee is eligible to participate if they received at least $5,000 in compensation during any two preceding years and are reasonably expected to earn at least that amount in the current year. This rule is not tied to an employee’s age or years of service.

Comparing Contribution Rules

The mechanics of how money flows into SEP and SIMPLE IRAs represent a significant divergence. A SEP IRA is funded exclusively by the employer; employees are not permitted to make their own contributions to the plan. This design places the full responsibility for funding on the business.

Conversely, a SIMPLE IRA is structured to accommodate contributions from both the employee and the employer. Employees can elect to defer a portion of their salary into their SIMPLE IRA, up to an annual limit. The employer is then required to make a contribution on behalf of the employee.

Employer contributions to a SEP IRA are entirely discretionary. The business owner can decide each year whether to contribute and how much, from zero up to the legal maximum. This flexibility allows a business to adjust its retirement plan outlay based on annual profitability, as contributions can be skipped during lean years.

The employer contribution for a SIMPLE IRA is mandatory every year. The employer must choose one of two contribution methods. The first option is a dollar-for-dollar match of the employee’s salary deferrals, up to a maximum of 3% of the employee’s compensation. The second is a non-elective contribution of 2% of compensation for every eligible employee, regardless of whether they contribute.

Contribution limits also vary substantially. For a SEP IRA, the employer can contribute up to 25% of an employee’s compensation, not to exceed $70,000, with a maximum compensation base of $350,000. For a self-employed individual, compensation is defined as net adjusted self-employment income, which results in an effective contribution rate of 20%. For example, a sole proprietor with $100,000 in net adjusted self-employment income could contribute $20,000.

For a SIMPLE IRA, an employee can contribute up to $16,500 from their salary. Participants age 50 and over can make additional catch-up contributions of $3,500. A higher limit of $5,250 applies to participants aged 60, 61, and 62.

Establishment and Administrative Obligations

Setting up either a SEP or SIMPLE IRA requires the employer to execute a formal written agreement, and the IRS provides model plan documents to simplify this. For a SEP IRA, an employer uses Form 5305-SEP. For a SIMPLE IRA, the common documents are Form 5304-SIMPLE or Form 5305-SIMPLE, depending on whether the employer allows employees to select their own financial institution.

These forms are used to define the plan’s terms. The employer must specify which employees are eligible and, for a SEP IRA, state the contribution formula. For a SIMPLE IRA, the document must outline the employer’s contribution choice.

The deadlines for establishing these plans differ. A SEP IRA offers significant flexibility, as it can be established as late as the due date of the business’s income tax return for the year, including any extensions. For a sole proprietorship filing an extension, this could mean a deadline as late as October 15 of the following year.

A SIMPLE IRA has a much stricter establishment deadline and must be established by October 1 of the year for which it is to be effective. The SIMPLE IRA also carries a mandatory annual notification requirement. Employers must inform employees of their right to make salary deferrals and describe the employer’s contribution for the upcoming year.

Additional Comparative Factors

An employer generally cannot maintain any other qualified retirement plan, such as a 401(k), during the same calendar year that they offer a SIMPLE IRA. This limitation makes the SIMPLE IRA a standalone option for small businesses. The SEP IRA provides more flexibility, as it can be maintained alongside other types of retirement plans.

Withdrawal rules for both plans are governed by standard IRA regulations, including a 10% penalty on distributions taken before age 59.5. However, the SIMPLE IRA has a unique and more stringent penalty for early withdrawals. If a participant takes a distribution within the first two years of their initial participation in the plan, the penalty increases from 10% to 25%.

The ability to move funds through a rollover also has specific restrictions. While funds from a SEP IRA can be rolled over to other IRAs or qualified plans, the SIMPLE IRA is subject to a two-year waiting period. During the first two years of participation, funds from a SIMPLE IRA can only be rolled over to another SIMPLE IRA.

Plan loans are another point of distinction. Loans are never permitted from a SEP IRA because the underlying account is a traditional IRA. While the regulations for SIMPLE IRAs do not strictly forbid loans, they are not a feature of plans established using standard IRS model forms, making them generally unavailable.