By Jamie Johnson, WCI Contributor
If you’re self-employed or you run a small business, saving for retirement can be a bit tricky. And if you want to offer retirement benefits to your employees, 401(k)s can be costly to set up and manage. That’s why SEP IRAs and SIMPLE IRAs are popular options for many small business owners. Both are employer-sponsored plans that give you and your employees a way to save for retirement. Here at WCI, we recommend every small business/practice owner with employees get a study done of their practice by someone who specializes in retirement accounts for small businesses. The right plan for your practice may be a SEP, a SIMPLE, a 401(k), or even no plan at all.
It’s important to understand some of the critical differences between the SEPs and SIMPLEs. Having this information will help you determine which is the best option for your business and employees.
What Is a SEP IRA?
A simplified employee pension (SEP) plan lets employers set aside funds in retirement accounts for themselves and their employees. It’s also a good option for the self-employed.
As an employer, you can make tax-deductible contributions on behalf of any eligible employees. To qualify for a SEP IRA, employees must have earned at least $650.
These retirement accounts are easy to set up, and they come with low costs. Employers can decide how much they want to contribute, and these plans are available to businesses of all sizes. But only employers can contribute to a SEP IRA; employees are not allowed to contribute to their own plans.
How Does a SEP IRA Work?
When you open a SEP IRA, you won’t have many of the setup and operating costs that come with traditional employer-sponsored retirement plans. And a SEP plan allows business owners to contribute to their retirement at higher levels than what’s allowed with a traditional IRA.
A SEP plan is very similar to a traditional IRA and is treated the same way for tax purposes. Employers will receive a tax deduction for any money contributed to an employee’s SEP plan.
The account is funded with pre-tax money, so any contributions grow tax-deferred until retirement. When the money is withdrawn in retirement, that's when the employee will pay the taxes. Employees are eligible to participate in a SEP IRA if they meet the following requirements:
- Age 21 or older
- Earned at least $650 from the business in 2021 and 2022
- Have worked for your company for at least three of the last five years
Can You Have a SEP IRA and a 401(k)?
Yes, but only if the SEP IRA and 401(k) are offered by different companies. So, if you participate in an employer-sponsored 401(k) at a job, you can still set up a SEP IRA if you earn self-employment income through your business. Businesses often change from SEP IRAs to 401(k)s, but it is usually a good idea to make that change at the beginning of the calendar year to keep the paperwork as simple as possible.
SEP IRA Contributions
Many employers prefer SEP IRAs because you can make annual contributions to the plan. However, your contribution cannot exceed 25% of each employee’s current salary or $58,000 annually—whichever figure is lower. For 2022, that number is increasing to $61,000.
These contribution limits are significantly higher than what you’d get with a standard IRA ($6,000 for 2022), even if you qualify for catch-up contributions. And business owners are not locked into annual contributions—you can re-evaluate whether you want to contribute each year.
What Is a SIMPLE IRA?
A SIMPLE (Savings Incentive Match Plan for Employees) IRA is similar to a traditional IRA, but employers set it up for themselves and their employees. It’s designed for small businesses with 100 employees or less.
Small business owners often choose to set up a SIMPLE IRA instead of a 401(k). The account comes with fewer costs, and the federal reporting requirements are easier. However, the contribution limits are also lower than what you would receive with a 401(k).
How Does a SIMPLE IRA Work?
When you open a SIMPLE IRA, you and your employees can contribute a percentage toward retirement. Like a SEP IRA, pre-tax money is contributed, and it will grow tax-deferred. Taxes will be paid at withdrawal in retirement.
Employees are eligible to contribute if they meet one of the following requirements:
- They’ve earned at least $5,000 during any two years before the current calendar year
- They expect to make at least $5,000 in compensation during the current calendar year
As an employer, you can make the eligibility requirements less restrictive for employees, but you cannot add more restrictions. And if you choose to offer a SIMPLE IRA, you cannot have any other retirement plans.
SIMPLE IRA Contributions
If you offer a SIMPLE IRA to your employees, you must decide annually how much you’re going to contribute. You can choose between the following two contribution methods:
- Contribute 2% of every eligible employee’s salary, regardless of whether they contribute or not
- Match each employee’s contribution on a dollar-for-dollar basis up to 3% of each employee’s salary
In 2021, the annual SIMPLE contribution limit for employees is $13,500. In 2022, the annual contribution limits are increasing to $14,000 (for context, the 401(k) contribution limit for 2022 is $20,500). Employees over the age of 50 can also make annual catch-up contributions of $3,000.
Difference Between a SEP and SIMPLE IRA
A SEP IRA and a SIMPLE IRA are popular options for small business owners. These plans allow you to contribute money toward your retirement savings beyond what a traditional IRA will allow.
Many small businesses choose one of these plans because they are simpler and less costly to set up than a 401(k). However, there are a few key differences you should know about—these disparities are outlined in the following table.
When Do Doctors Use SEPs and SIMPLEs in Real Life?
A SEP-IRA is a great account for an independent contractor with no employees. While an individual 401(k) is usually a better choice (you can often get more money in there and it avoids pro-rata issues with the Backdoor Roth IRA), some choose to use a SEP-IRA because it can be set up after the calendar year is over. The pro-rata issue can also be avoided by doing immediate Roth conversion of your contributions. If you don't care about the Backdoor Roth IRA (or Congress outlaws it) and already make your annual employee 401(k) contribution into another 401(k) for another employer, a SEP works just fine and requires less paperwork than an individual 401(k).
Dentists and other small practices often choose a SIMPLE IRA because it is, well, simple. It also generally requires smaller contributions on behalf of the employees. While it doesn't allow as large of contributions as a 401(k), the dentist owner often views it as “better than nothing.”
SIMPLE IRA vs SIMPLE 401(k)
There is also an entity out there called a SIMPLE 401(k). Think of it as a cross between a SIMPLE IRA and a 401(k). Contribution amounts are the same, but the employer contributions work a little bit differently and a SIMPLE 401(k) can allow plan loans. Exclusion rules are also different. A SIMPLE 401(k) can exclude everyone under age 21; a SIMPLE IRA cannot. A SIMPLE IRA can require employees to earn at least $5,000 for the previous two years; a SIMPLE 401(k) has to include employees who have been there for a year.
The Bottom Line
SEP and SIMPLE IRAs are excellent options for anyone self-employed or who runs a small business. These accounts let you stash away more money for your retirement savings than a traditional IRA will allow.
Both plans allow you to contribute to eligible employees’ retirement savings. These contributions are tax-deductible expenses that will lower your overall self-employment taxes.
However, a SEP IRA is a better option for larger companies or anyone who needs flexibility around their annual contributions (white coat investors also would likely prefer a SEP IRA to a SIMPLE IRA). If you have fewer than 100 employees and want to give your employees the option to contribute to their retirement savings, the SIMPLE IRA may be the best option.
If you need extra help with planning for retirement or have questions about the best way to save your money in tax-protected accounts, hire a WCI-vetted professional to help you figure it out.
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