If you’re a small business owner interested in setting up a retirement savings plan for yourself and your employees, two of the most popular options are the SEP IRA and the SIMPLE IRA. Both are easy to set up and allow employees to make tax-deferred contributions.
I’m sure you’ve heard of traditional and Roth IRAs, but SEP and SIMPLE IRAs are both employee-sponsored. There are a couple of other similarities, but the differences and key features of each can make one a much better retirement savings vehicle for you and your employees.
SEP IRA vs SIMPLE IRA – What is the difference between a SEP and a SIMPLE IRA?
What are SEP and SIMPLE IRAs?
Both the SEP IRA and SIMPLE IRA are tax-advantaged accounts that employers (that includes self-employed people, like freelancers) can use for their retirement savings. These plans are both easy to set up and can be managed through an online brokerage.
One of the downsides to being self-employed is that while traditional employers may offer a 401(k) or pension plan, you’re solely responsible for your retirement savings. Fortunately, there are a few options you can take advantage of if you work for yourself.
Define SEP IRA
Let’s start with the basics. SEP stands for Simplified Employee Pension. It’s an employer-sponsored retirement plan that’s most commonly used by small business owners and self-employed people who want to save for retirement. One of the major benefits to employers is that they may make tax-deductible contributions on behalf of their employees.
I’m going to explain these in more detail, but here are the key takeaways:
- SEP IRAs are employer-sponsored retirement accounts, which includes self-employed people
- SEP contribution limits are much higher than standard IRAs
- Only employers make contributions to the account
- SEP IRAs function like a traditional IRA
SEP contributions are significantly higher compared to standard IRAs. A standard IRA has a contribution limit of $6,000 for 2021, with a catch-up limit if you’re age 50 or older.
However, SEP contributions cannot exceed the lesser of 25% of the employee’s compensation for the year or $58,000. The limit on compensation is $290,000 for 2021. You can expect to see regular cost of living adjustments to those minimums, just like you would see with a standard IRA.
The employer is the one who makes contributions to this plan, and they must contribute an equal percentage to all employees. So if you’re the business owner and contribute 10% of your wages to your SEP IRA, you’ll need to contribute 10% of each of your employees’ wages to theirs as well. If you’re a solopreneur, you’d just be contributing to your account, since you don’t have any employees.
Employees have full control over their money immediately, so 100% is fully vested.
SEP IRAs work like a traditional IRA, meaning you’re not taxed on those investments until you withdraw them in retirement. You cannot make Roth contributions, meaning after-tax contributions, to a SEP IRA.
Related: Blooom Review 2021: An Affordable Robo-Advisor for Your 401k
Define SIMPLE IRA
SIMPLE stands for Savings Incentive Match Plan for Employees. SIMPLE IRAs are available for employers with no more than 100 employees, each earning more than $5,000 in the previous year.
Here are the key takeaways with SIMPLE IRA:
- SIMPLE IRAs are less complex than a 401(k), with an easier set-up and reporting process
- SIMPLE IRAs encourage employees to contribute to their retirement
- The major drawback for employers is that the business owner can’t save as much as they could with other kinds of retirement accounts
The sheer lack of paperwork is one of the most appealing aspects of a SIMPLE IRA. It only requires an initial plan document and annual disclosure sent out to employees. The employer sets up the plan through a financial institution to administer it, like Fidelity, Charles Schwab, or Vanguard.
Not only is the paperwork simple, but SIMPLE IRAs also have low startup and maintenance costs. Employers can also take a tax deduction for contributions they make for their employees.
SIMPLE IRA contribution limits are $13,500 for 2021 and $16,500 for employees who are 50 and over. Employees are obligated to make contributions to their employees’ SIMPLE IRA, and they can choose one of two ways:
- Non-elective contributions of 2% of the employee’s salary (non-elective means the contribution is made whether or not the employee contributes)
- Dollar-for-dollar matching contributions up to 3% of their salary (employers only contribute if the employee does)
The $13,500 contribution limit applies to you the business owner because you’re also considered an employee.
Like SEP IRAs, SIMPLE IRA contributions are tax-deferred. That means money is only taxed when it’s withdrawn.
Want to know where to set up a SEP IRA? Check out 5 Best SEP IRA Providers of 2021 to learn about your options.
SEP IRA vs SIMPLE IRA
Both SIMPLE IRAs and SEP IRAs are retirement plans that small business owners can set up for both themself and their employees. While they’re similar in several ways, there are key differences to think about it.
Header | SEP IRA | SIMPLE IRA |
|---|---|---|
Tax status | Tax-deferred | Tax-deferred |
Who contributes? | Employer | Employer and/or employees |
Contribution limit | Whichever is less: 25% of an employee’s salary or up to $58,000 | $13,500 |
Catch-up contributions | $6,500 | $3,000 |
Both SEP IRAs and SIMPLE IRAs work like traditional IRAs with tax-deferred contributions, and neither allow for Roth contributions.
The employer makes contributions in both kinds of retirement accounts. It’s the sole responsibility of the employer with a SEP IRA. With SIMPLE IRAs, employers have two contribution options: non-elective contributions of 2% of an employee’s wages or dollar-for-dollar matching contributions of up to 3% of an employee’s wages.
SEP IRAs have much higher contribution limits of up to $58,000, and employers must contribute to their employee’s retirement savings if they contribute to their own. SEP IRAs can be a much better fit for businesses with fluctuating cash flow because you’re not obligated to make annual contributions.
If you’re a solopreneur, a Solo 401(k) is potentially an even better option, and you can learn more in What is a Solo 401(k)?
The final word on SEP IRA vs SIMPLE IRA
If you are a small business owner, both a SEP IRA and SIMPLE IRA are solid options if you want to save for your own retirement and your employees’.
The key difference between SEP and SIMPLE IRAs is how they’re funded. Employers are the only ones who can contribute to a SEP IRA. But employees can contribute to a SIMPLE IRA if they want. Not only that, it’s incentivized with employer contributions.
Employers have more flexibility with SEP IRAs, which is much better if your business has fluctuating cash flow – contribute when business is strong, but reduce contributions or cut them out entirely during downturns.
Weigh up the differences between the two and speak with a financial advisor if you have any questions about how the nuances will affect you and your business.
FAQs
As long as you’re not the owner of your employer’s business, you can contribute the maximum to both plans. The contribution limits are separate for both plans.
SEP IRAs have advantages for both employees and employers. As the employee, your employer makes contributions for you, and those contributions can be as high as $58,000 a year.
But as the employer, you’re not obligated to make contributions. That means if you have a tight year, you can pull back on what you contribute. When business picks back up, you can resume normal contributions.
Yes, employees can contribute to both their own retirement plans and an employer-sponsored retirement plan.
SEP IRAs are traditional IRAs with tax-deferred contributions. That means you’re taxed when you withdraw money in retirement. The same goes for SIMPLE IRAs.
About Millennial Money Man
Bobby Hoyt is a former band director who paid off $40,000 of student loan debt in 18 months on his teaching salary and then left his job to run Millennial Money Man full-time. He helps other Millennials earn more through side hustles, save more through budgeting tools and apps, and pay off debt. He is a personal finance expert who has been seen on Forbes, Reuters, MarketWatch, CNBC, International Business Times, Business Insider, US News, Yahoo Finance, and many other personal finance and entrepreneurship media outlets.
