What’s the Difference Between a SEP and SIMPLE IRA?

Small businesses and self-employed individuals seek effective strategies to save for retirement and offer employee benefits. Retirement plans defer income taxes while accumulating savings. Two popular options for smaller entities are the Simplified Employee Pension (SEP) plan and the Savings Incentive Match Plan for Employees (SIMPLE) plan, both structured as Individual Retirement Arrangements (IRAs). These plans offer distinct advantages and cater to different business structures and financial objectives.

Simplified Employee Pension (SEP) Plans

A SEP plan is a retirement savings vehicle for self-employed individuals and small business owners. Employers make contributions to traditional IRAs for themselves and their eligible employees. SEPs rely solely on employer contributions; employees cannot contribute their own funds.

SEP IRA contributions are discretionary, allowing employers flexibility to contribute varying amounts or skip contributions based on profitability. Contributions are tax-deductible business expenses. For 2024, the maximum contribution is the lesser of 25% of an employee’s compensation or $69,000, adjusted annually for inflation.

Eligibility generally includes employees at least 21 years old, who have worked for the employer in at least three of the preceding five years, and earned at least $750 in 2024. Contributions must be a uniform percentage of compensation for all eligible employees, including the owner. Each participant establishes their own SEP IRA.

SEP plan administration is straightforward compared to other retirement plans like a 401(k). Setup involves IRS Form 5305-SEP or a prototype agreement from a financial institution. Ongoing administrative requirements are minimal, with no annual filing requirements if using the IRS model form. Funds are subject to traditional IRA withdrawal rules. Distributions before age 59½ may incur a 10% early withdrawal penalty, plus regular income tax, unless an exception applies.

Savings Incentive Match Plan for Employees (SIMPLE) Plans

A SIMPLE IRA is a retirement savings plan for small businesses with 100 or fewer employees. It permits both employee salary deferrals and mandatory employer contributions. Employees can contribute a portion of their pre-tax salary, similar to a 401(k).

For 2024, employees can defer up to $16,000, with a $3,500 catch-up contribution for those aged 50 or over. Employers must make contributions: either a dollar-for-dollar match up to 3% of compensation, or a non-elective contribution of 2% of compensation, regardless of employee deferral.

Eligibility includes employees earning at least $5,000 in any two preceding calendar years and expected to earn $5,000 in the current year. All eligible employees must participate. Contributions go to individual SIMPLE IRA accounts.

SIMPLE IRA administration is more involved than a SEP but less complex than a 401(k). Employers establish the plan using IRS Form 5304-SIMPLE or 5305-SIMPLE, or a similar document. No annual Form 5500 filings are required. Employees are immediately 100% vested. Funds withdrawn within the first two years of participation incur a 25% early withdrawal penalty, reverting to 10% after two years for withdrawals before age 59½, unless an exception applies.

Comparing SEP and SIMPLE Plans

SEP and SIMPLE plans offer simplified retirement solutions for small businesses, but differ in mechanics. SEP plans are employer-funded and discretionary. SIMPLE plans involve both employee deferrals and mandatory employer contributions (matching or non-elective).

Contribution limits differ. SEP IRAs allow up to $69,000 (25% of compensation), potentially higher for owners. SIMPLE IRA employee deferrals are capped at $16,000 ($19,500 with catch-up), with employer contributions at 3% match or 2% non-elective.

SEP contributions are discretionary, offering flexibility for fluctuating profits. SIMPLE plans mandate annual employer contributions, a continuous financial obligation. SIMPLE plans generally require broader employee eligibility than SEP plans.

SEP plans have lower administrative burden, with less paperwork and no employee deferral management. SIMPLE plans, while simpler than a 401(k), require managing deferrals and mandatory contributions. SIMPLE IRAs are limited to businesses with 100 or fewer employees; SEP plans have no such restriction. SIMPLE IRAs have a 25% early withdrawal penalty within the first two years of participation, unlike SEP IRAs.

Selecting a Retirement Plan

Choosing between a SEP and SIMPLE IRA involves evaluating business needs, including size, employee demographics, and financial objectives. For self-employed individuals or businesses with few employees, a SEP plan is appealing, especially if maximizing owner contributions and maintaining flexibility is the goal. Discretionary employer contributions allow adjustments based on annual profitability.

Alternatively, for small businesses with up to 100 employees aiming to encourage employee savings and willing to commit to mandatory employer contributions, a SIMPLE IRA is suitable. Employees contribute directly from paychecks, fostering ownership. Mandatory employer contributions provide a consistent benefit for employee retention and recruitment.

Consider administrative involvement. SEP plans require less ongoing administration, appealing for minimal paperwork. SIMPLE plans are more involved due to managing deferrals and mandatory contributions, but less complex than 401(k)s. Ultimately, the decision balances owner savings maximization versus broad employee participation, considering consistent employer contributions and administrative oversight.

References

IRS. (2023, November 14). Retirement Topics – SEP (Simplified Employee Pension) Plan. Retrieved from https://www.irs.gov/retirement-plans/retirement-topics-sep-plan
IRS. (2023, November 14). Retirement Topics – SIMPLE IRA Plan. Retrieved from https://www.irs.gov/retirement-plans/retirement-topics-simple-ira-plan
Small businesses and self-employed individuals often seek effective strategies to save for retirement and offer benefits to their employees. Retirement plans provide a way to defer income taxes while accumulating savings for the future. Two popular options designed for smaller entities are the Simplified Employee Pension (SEP) plan and the Savings Incentive Match Plan for Employees (SIMPLE) plan, both structured as Individual Retirement Arrangements (IRAs). These plans offer distinct advantages and cater to different business structures and financial objectives. Understanding their specific characteristics can help business owners make informed decisions about their long-term financial planning.

Simplified Employee Pension (SEP) Plans

A Simplified Employee Pension (SEP) plan serves as a retirement savings vehicle, primarily for self-employed individuals and small business owners. This plan allows employers to make contributions to traditional individual retirement accounts (IRAs) set up for themselves and their eligible employees. A significant characteristic of a SEP is its reliance solely on employer contributions, meaning employees cannot contribute their own funds to the plan.

Contributions to a SEP IRA are discretionary, allowing the employer flexibility to contribute varying amounts each year, or even to skip contributions in some years, based on business profitability. The employer can deduct these contributions as a business expense, which helps reduce the business’s taxable income. For 2024, the maximum contribution that can be made to a SEP IRA is the lesser of 25% of an employee’s compensation or $69,000. This amount is adjusted annually for inflation, with the limit increasing to $70,000 for 2025.

Eligibility for a SEP plan generally includes any employee who is at least 21 years old, has worked for the employer in at least three of the immediately preceding five years, and has received at least a certain amount of compensation for the year. For 2024, this compensation threshold is $750. When an employer makes a contribution, it must be a uniform percentage of compensation for all eligible employees, including the owner. Each eligible participant establishes their own SEP IRA to receive these contributions.

Administering a SEP plan is relatively straightforward compared to other retirement plans, such as a 401(k). The setup process is simple, typically involving the completion of IRS Form 5305-SEP or a prototype SEP agreement provided by a financial institution. Ongoing administrative requirements are minimal, as there are no annual filing requirements with the Department of Labor or the IRS if using the IRS model form. Once funds are contributed to an individual’s SEP IRA, they are subject to the same withdrawal rules as a traditional IRA. This means distributions before age 59½ may be subject to a 10% federal penalty tax, in addition to regular income tax, unless an exception applies.

Savings Incentive Match Plan for Employees (SIMPLE) Plans

A Savings Incentive Match Plan for Employees (SIMPLE) IRA is a retirement savings plan designed specifically for small businesses, generally those with 100 or fewer employees. This plan stands apart from SEP IRAs because it permits both employee salary deferrals and mandatory employer contributions. Employees can choose to contribute a portion of their pre-tax salary, similar to a 401(k) plan.

For 2024, employees can defer up to $16,000 of their compensation into a SIMPLE IRA. An additional catch-up contribution of $3,500 is allowed for employees aged 50 or over, bringing their total possible contribution to $19,500 for 2024. Employers are required to make contributions to the plan, choosing one of two options: either a dollar-for-dollar matching contribution up to 3% of the employee’s compensation, or a non-elective contribution of 2% of each eligible employee’s compensation. The 2% non-elective contribution must be made regardless of whether the employee chooses to defer their own salary.

Eligibility for a SIMPLE IRA typically includes employees who received at least $5,000 in compensation during any two preceding calendar years and are reasonably expected to receive at least $5,000 in the current calendar year. All eligible employees must be allowed to participate in the plan. Like SEP IRAs, contributions are made to individual SIMPLE IRA accounts established for each eligible employee.

The administration of a SIMPLE IRA is more involved than a SEP but less complex than a 401(k). Employers must establish the plan using IRS Form 5304-SIMPLE or Form 5305-SIMPLE, or a similar plan document from a financial institution. There are no annual Form 5500 filings required for SIMPLE IRAs. Employees are immediately 100% vested in all contributions.

Withdrawals from a SIMPLE IRA are generally subject to income tax for the year received. If funds are withdrawn from a SIMPLE IRA within the first two years of an employee’s initial plan participation, the standard 10% early withdrawal penalty increases to 25%, in addition to regular income tax, unless an exception applies. After this two-year period, the penalty reverts to the standard 10% for withdrawals before age 59½.

Comparing SEP and SIMPLE Plans

SEP and SIMPLE plans both offer simplified retirement savings solutions for small businesses, but they differ significantly in their operational mechanics and suitability for various business contexts. A primary distinction lies in who contributes to the plan. SEP plans are funded solely by employer contributions, offering employers complete discretion over annual contribution amounts. In contrast, SIMPLE plans involve both employee salary deferrals and mandatory employer contributions, which can be either a matching contribution or a fixed non-elective contribution.

Contribution limits also vary between the two plans. For 2024, SEP IRA contributions can be as high as $69,000, representing the lesser of 25% of compensation or the stated dollar limit, which generally allows for higher employer contributions for high-earning individuals compared to SIMPLE IRAs. SIMPLE IRA employee deferrals are capped at $16,000, with an additional $3,500 catch-up contribution for those aged 50 and over, while employer contributions are either a 3% match or a 2% non-elective contribution. This difference means SEP plans can potentially allow for much larger contributions for the business owner if they are the primary or sole participant.

Employer contribution requirements represent another key divergence. SEP contributions are discretionary, providing flexibility for businesses with fluctuating profits. Conversely, SIMPLE plans mandate employer contributions every year, either as a match to employee deferrals or a non-elective percentage of compensation, which can be a continuous financial obligation. Regarding employee participation, SIMPLE plans generally require broader employee eligibility, covering those earning at least $5,000 in prior years.

Administrative burden is generally lower for SEP plans, as they involve less ongoing paperwork and no employee deferral management. SIMPLE plans, while still simpler than a 401(k), require managing employee deferrals and ensuring mandatory employer contributions are made. Furthermore, SIMPLE IRAs have an employee count restriction, limiting participation to businesses with 100 or fewer employees, whereas SEP plans do not have such a limitation. Finally, withdrawal rules for SIMPLE IRAs include a specific 25% early withdrawal penalty if distributions occur within the first two years of participation, a rule not present in SEP IRAs.

Selecting a Retirement Plan

Choosing between a SEP and a SIMPLE IRA involves evaluating a business’s specific needs, including its size, employee demographics, and financial objectives. For self-employed individuals or businesses with only a few employees, particularly if the goal is to maximize contributions for the owner and maintain flexibility, a SEP plan often presents an appealing option. The discretionary nature of employer contributions in a SEP allows business owners to adjust contributions based on annual profitability, which can be beneficial during periods of varying income.

Alternatively, if a small business with up to 100 employees aims to encourage employee savings through their own contributions and is willing to commit to mandatory employer contributions, a SIMPLE IRA may be more suitable. This plan allows employees to directly contribute from their paychecks, fostering a sense of ownership over their retirement savings. The mandatory employer contributions in a SIMPLE plan also provide a consistent benefit for employees, which can be a valuable tool for employee retention and recruitment.

Consideration should also be given to the desired level of administrative involvement. SEP plans generally require less ongoing administration, making them attractive for those seeking minimal paperwork and compliance tasks. While SIMPLE plans are more involved due to managing employee deferrals and mandatory employer contributions, they remain significantly less complex than larger plans like 401(k)s. Ultimately, the decision hinges on balancing the desire for owner-centric savings maximization versus the goal of promoting broad-based employee participation and savings, alongside the business’s capacity for consistent employer contributions and administrative oversight.