How Do a Simplified Employee Pension (SEP) IRA and SIMPLE IRA Differ?

Nov 24, 2023 By Susan Kelly

The SEP and Simple IRA offer retirement plans suitable for small companies and sole proprietors or self-employed persons. According to a report from April 2019 by SCORE, a group of business mentors who aid small businesses in getting up and running and growing, only 28% of businesses with less than 10 employees offer a retirement program. This is large because 401(K) plans are very labor-intensive, and plan administrators don't often want to collaborate with small companies.


There are many similarities and differences between SEP IRA vs. Simple IRA. Examining the advantages that each account offers as well as having a comparison of the two of the accounts will help self-employed individuals and small-business managers make the right choice about the retirement savings they will have.


What Is a SIMPLE IRA?


SIMPLE IRA functions fairly similar to the traditional IRA; however, it has higher contributions limits. Anyone who does not have access to a company savings plan such as a 401(k) can set up a traditional IRA. Small business owners or a company's sole proprietor can establish a SIMPLE IRA for their employees and themselves. Anyone who earned at least $5,000 in salary from the company two years before the present year and expects to earn at least the same amount in the calendar year that is currently in effect can participate in the plan.


Employers who qualify can opt for deferrals on their own. It's similar to the 401(k) scheme, allowing employees to defer a specific amount of their income before tax to the plan. Employers may contribute to employee accounts by matching employee contributions or making a non-elective contribution. If it is a non-elective contribution, the employer can decide to transfer money to an employee's account, regardless of whether or not the participant was a part of the plan during the year.


In contrast to other kinds of retirement plans, it is not possible to decide to opt-out of participation in the SIMPLE IRA if you are qualified. You can choose not to deposit money into your account; however, you will have to receive non-elective corporate contributions if, for any reason, you aren't interested in receiving free cash.


What Is a SEP-IRA?


A "SEP" part of SEP-IRA refers to a "simplified employee pension." It's not as simple as it sounds and likely depends on your level of trust in your financial situation. SEP-IRA is a good way to simplify the tax-deferred savings procedure for self-employed entrepreneurs and small-sized business owners. Additionally, it provides savings options for employees of small-sized businesses.


In contrast to other retirement plans employees offer to employees, an employee enrolled in the SEP-IRA plan isn't required to contribute to the plan themselves. It is the company that contributes contributions directly to them. In 2021, employers can contribute up to 25 percent of an employee's earnings or $58,000, or less, whichever is the lesser. In 2022, the employer can contribute up to 25 percent of the employee's pay or $61,000 or less. Employers can choose when they contribute, and they aren't required to do it every year. The owner and all business employees must receive the same amount of their salary.



Employer Contribution Limits


The high level of SEP-IRA contributions by employers that, in 2022, is up to 25 percent of an employee's income or $61,000, whichever is lower, could be an effective incentive to attract new employees and keep current ones. It's also a method for employers to recognize their most important employees. If an employer opts to contribute 2 percent of an employee's pay up to a limit of $305,000 in the SIMPLE IRA plan, the maximum amount they can put in is $6100 (2 percent of $305,000), which is exactly 10% of their SEP IRA's maximum.


Tax Implications



Both SIMPLE and SEP IRAs are tax-deferred accounts financed with tax-free dollars. They result in a lower taxable income. But, once the money in any account is depleted at retirement, it will be taxed according to the account holder's standard tax rate. A SEP IRA and a SIMPLE IRA can be considered for employees who believe the tax rate will be lower after retirement. Still, for those who anticipate their tax bracket to increase throughout the course of retirement, the Roth IRA may make more sense as it is built with tax-free dollars after the fact, and withdrawals in the retirement period are not tax-deductible.

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