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Offering your employees generous benefits packages that include retirement plans is crucial for both attracting top talent and retaining it. But as you’re looking into potential retirement plan options, you may be confused about parsing the difference between SIMPLE IRAs vs. SEP IRAs.
In truth, there are a lot of similarities between these two types of retirement plans. Both are employer-sponsored, tax-advantaged retirement accounts, and both are suitable for both small business owners with employees as well as self-employed individuals. Obviously, there are some key differences between SIMPLE IRAs vs. SEP IRAs, the most notable being how they’re funded and their contribution limits.
In this SEP IRA vs. SIMPLE IRA comparison, we’ll walk you through both types of retirement accounts and the types of businesses each works best for. We’ll also provide you with a couple additional retirement plans you can consider setting up for your employees, including one account that’s suitable especially for self-employed folks.
SIMPLE IRA may seem like an apt name in itself, but it’s actually an acronym for Savings Incentive Match Plan for Employees. (The IRA, as usual, stands for “individual retirement account.”) This retirement plan is suitable for any small business with 100 or fewer employees who each make at least $5,000 a year.
According to the IRS, the SIMPLE IRA is a good starter plan for small business owners to offer their employees because it’s comparatively simple (as the name implies) to set up and manage. A few other benefits? SIMPLE IRAs have low set-up and operating costs, employers are not beholden to an annual filing requirement, and eligibility requirements are relatively lax.
SIMPLE IRAs allow both employees and employers to contribute to employees’ retirement accounts. More specifically, employers must contribute, and employees may contribute.
Each year, employees can elect to contribute a certain percentage of their pre-tax compensation to their SIMPLE IRA plan, up to the limit set by the IRS every year. In 2020, the maximum amount an employee can contribute to their SIMPLE IRA is $13,500, but employees aged 50 and over can also make catch-up contributions up to $3,000.
Then, employers must contribute either a matching contribution of up to 3% of each of their employees’ compensation, or set up a non-elective contribution. If they choose the latter, they must contribute 2% of each eligible employee’s compensation up to the annual limit, regardless of whether the employee chooses to contribute themselves. Employees always own 100% of the contributions made to their SIMPLE IRA accounts.
As we mentioned, SIMPLE IRAs are available only for small businesses with 100 or fewer employees, including self-employed individuals with no employees. According to the IRS, any employee (including yourself, if you’re both your own employer and your own employee) who has earned at least $5,000 with your business during any two years before the current calendar year, and expects to earn the same in the current calendar year, is eligible to participate in a SIMPLE IRA.
SEP stands for “Simplified Employee Pension,” which should give you some sense of what a SEP IRA intends to do: Make it simple for employers to manage their employees’ retirement plans. SEP IRAs don’t have setup or operating costs, which makes this a good option for small business owners on tight budgets.
However, only employers can contribute to SEP IRAs—both their own, and on their employees’ behalf. Employees can’t elect to make their own contributions. This is a major differentiating factor from SIMPLE IRAs, which allow employees to make contributions to their own accounts if they so choose.
Each year, employers can make contributions to each employees’ account of up to 25% of their employees’ salaries, or up to $57,000 in 2020. So as an employer, you can shift your contribution amount however you see fit. That means you can contribute more during a lucrative year, or less when your cash flow is struggling. All your employees will receive the same percentage contribution, whether that’s as low as 1% or as much as the maximum 25%.
Any employer can establish a SEP IRA for their employees. According to the IRS, in order to be eligible to participate in a SEP IRA plan an employee (including self-employed people) must be at least 21 years old, have worked for the employer for at least three of the last five years, and earned at least $600 from the employer during the calendar year.
However, the IRS also notes that employers can choose to adjust their eligibility requirements to be less stringent than they’ve set, though not more so. That means that as an employer, you can choose not to enforce eligibility requirements regarding age, time with the company, earnings, or a combination of the above.
Since employers can adjust their contribution amounts each year, this is a good option for seasonal businesses, or businesses with frequent cash flow fluctuations.
While SIMPLE IRAs and SEP IRAs are excellent retirement plans for small business owners to look into, they’re certainly not your only options. Here are two more retirement plans to consider setting up for your employees, including one that’s designed especially for self-employed people.
Traditional and Roth IRAs are similar: Both are tax-advantaged retirement accounts, and both have the same annual contribution limit of $6,000 for 2020 (or $7,000 if you’re aged 50 or over). The major difference is that traditional IRA contributions are made in pre-tax dollars, and they’re tax-deductible in the year they’re made. When you make withdrawals from your traditional IRA in retirement, you will then pay taxes. Contributions to a Roth IRA are made in post-tax dollars according to your current tax bracket, but withdrawals made during retirement won’t be taxed.
Put more simply, if you think you’ll be in a lower tax bracket by the time you retire, then a traditional IRA might be the better choice for you. If you think your tax rate will be higher when you retire, set up a Roth IRA to make the most of its tax advantages.
Also known as a One-Participant 401(k) or a Solo-k, Self-Employed 401(k)s are essentially the same as traditional 401(k)s. But in this case, the retirement plan only covers a business owner with no employees and their spouse.
Under this plan, the account holder can make contributions both as an employer and an employee. As an employee, you can elect to defer up to 100% of your earned income up to the annual contribution limit, which is $19,500 for 2020. And as an employer, you can make an additional contribution of up to 25% of your compensation, as long as your total contributions don’t exceed the limit of $57,000 for 2020.
Self-Employed 401(k)s don’t have setup or ongoing maintenance fees, but you’ll need to file an annual report if your business earns more than $250,000 in assets.
When deciding between a SIMPLE IRA vs. SEP IRA, or one of the alternatives we mentioned, the major considerations to keep in mind are how each plan is funded, and their contribution limits.
More generally, SIMPLE IRAs work for business owners with employees who want to set up low-cost, easily manageable retirement plans for their staff. On the other hand, SEP IRAs are a great option for businesses for whom cash flow is an issue, since there are no employer contribution requirements, and employers can adjust their contribution amounts each year. Contribution limits are also more generous for SEP IRAs than SIMPLE IRAs. For those same reasons, SEP IRAs are especially good options for self-employed individuals.
We hope this guide to SIMPLE IRAs vs. SEP IRAs has provided you with a useful cheat sheet about these two popular retirement plans for small business owners. But even with this information under your belt, we still recommend consulting with an accountant, financial advisor, or other small business expert before committing to either of these or another type of retirement plan. We know you want to provide the best possible fringe benefits for your employees (and yourself!), so it’s worth doing a little extra due diligence.