An IRA is an incredibly common way to save for retirement, and while the traditional and the Roth IRA are quite well-known, the SEP and the SIMPLE IRA are less familiar. They are both very effective retirement plans for business owners, and since they are simple to set up and relatively affordable to maintain, they are gaining popularity rapidly. This has led many business owners to wonder what the pros and cons of the SEP IRA and the SIMPLE IRA are and how they compare.
A SIMPLE IRA is a good fit for businesses with less than 100 employees, with steady revenue and profits, and must be opened by the business owner themselves. A SEP IRA is better for companies with fluctuating income and can be opened by the owner, proprietor, or anyone self-employed.
There are a lot more differences than that, however, as well as some significant similarities. Each one is specifically created to allow effective retirement planning for different individuals and organizations. We're going to take a close look at SEP IRAs and SIMPLE IRAs, focusing on these differences and what the individual pros and cons are for each.
What Are Pros And Cons Of SIMPLE vs. SEP IRA
There are some considerable differences between a SIMPLE and SEP IRA and some notable pros and cons for each as well. While some may find some of the cons to be major, they may not matter that much to others. Some of the most prominent differences lie in who can contribute, who opens the account in the first place, and the contribution limitations.
Pros And Cons Of A SIMPLE IRA
SIMPLE IRAs, also known as Savings Incentive Match Plan for Employees Individual Retirement Accounts, are retirement accounts set up for owners of a business as well as their employees. One of the biggest benefits of a SIMPLE IRA is that not only can the employee contribute to it, but the business owner can as well. This makes them ideal for situations when the employer wants to set up a matching program and for businesses that have 100 employees or fewer.
The SIMPLE IRA can be used by any employee who earns more than $5,000. However, once the employee is eligible to participate, their participation is required. The contributions of employees are taken from their pre-tax dollars, though there is an option to opt out of the contributions. Employers that set up SIMPLE IRAs are required to make contributions in one of two different ways.
The first option is that the employer can choose to contribute a matching contribution for each employee. This contribution matching can be up to 3% of the employee's yearly salary. The other option is that they can contribute to the plan regardless of the employee's contribution status or amounts. This option will allow the employer to contribute a mandatory flat rate of 2% of the yearly salary for the employee, up to a total of $305,000 per year.
The contributions to a SIMPLE IRA are tax-deductible, and the limit on an employee's contributions is set at $14,000 per year at the time of writing. The only exception is for employees over age 50, who are allowed to make catch-up contributions with a limit of $17,000 per year.
One of the primary drawbacks of a SIMPLE IRA is that it cannot be used in conjunction with any other form of retirement plan sponsored by the employer. For example, you cannot contribute to a SIMPLE IRA and also contribute to a SEP IRA or to an employer-sponsored 401(k).
Another con of the SIMPLE IRA is that they will impose a fee of 10% if the money is used before the employee reaches age 59 ½. This penalty jumps to 25% if the account has only been open for two years or less.
Pros And Cons Of A SEP IRA
A Simplified Employee Pension IRA or SEP IRA is also set up by the employer but can also be used by those who are self-employed. While a SEP IRA can be used by a business of any size, they are best suited for smaller organizations and sole proprietorships. They are comparatively easy to set up, and the fees for managing the funds are often much lower than any other similar retirement savings plan.
A SEP IRA will be set up by the employer, and they will also be the only contributor to the plan, which some may have guessed when seeing "pension" in the name. The benefit of this type of plan is that it can be used much more effectively for smaller businesses that are seasonal or have a fluctuating income. The reason they are better for businesses with inconsistent income is that the employer can decide the contribution amount and frequency.
The contribution limit for a SEP IRA is capped at 25% of an employee's salary, or $61,000, whichever is lower. One of the drawbacks to this model is that the business owner and all participating employees must contribute at the same rate.
A primary benefit of the SEP IRA model is that the funds become immediately vested since the contributions do not come from the individual employee paychecks. This leaves the employees free to manage the assets and investments in their SEP IRA.
Another incredible benefit of the SEP IRA model is that it has a twofold tax benefit. First, the employers are able to count their contributions as tax deductions, so it lowers their year-end tax liability. Second, the employees receiving the contributions do not have to count those contributions as taxable income, which prevents an increase in their personal tax liability. Since the money in a SEP IRA is tax-deferred, it doesn't qualify for taxation until it is eventually withdrawn.
SEP IRA vs SIMPLE IRA vs Solo 401(k)
Now that you've seen the pros and cons of the SEP IRA and the SIMPLE IRA, you certainly have some considerations to make, but you're probably also wondering how these two plans compare to other common retirement savings plans. One of the most common plans to compare these two is the solo 401(k). Here's how they each stack up to each other and how they compare to a solo 401(k) plan so that you can make the most educated choice when laying out your plans to save for retirement.
The SEP IRA is the perfect solution for anyone self-employed or who owns a business with any number of employees. The business owner will be the one to create and set up the IRA, and they will also be the sole contributor. These IRAs are best-suited for organizations that do not have a consistent level of revenue or profit and allow the employer to adjust the contribution amounts and contribution frequency as they see fit.
They also tend to have a larger cap than a SIMPLE IRA or a solo 410(k) since the contribution is capped at one-quarter of an employee's salary, or $61,000, whichever is less.
The SIMPLE IRA is great for the self-employed or those who own businesses with under 100 employees since they are often much more affordable to maintain than employer-sponsored 401(k) accounts. They are more flexible than both a 401(k) and a SEP IRA since both the employer and the employee are able to contribute to the account.
However, they also have one of the lowest contribution caps, at just $14,000 for those under 50 and only $17,000 for those 50 and older.
The best use for a solo 401(k) plan is for an entrepreneur that has started their own business and has no other employees besides themselves. They follow many of the same guidelines as the traditional employer-sponsored 401(k), though they do have one or two major differences.
As of the time of writing, the solo 401(k) plan contributions are tax-deferred and capped at $20,500 for those contributors younger than 50 years old, with an additional $6,500 catch-up contribution allowed for those 50 or over. This means that the contributions are not taxed until they are withdrawn from the account.
Additionally, the spouse of the entrepreneur can contribute to a solo 401(k). However, unlike an employer-sponsored 401(k), there cannot be a contribution match from the company's coffers.
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Knowing The Pros & Cons Of A SEP IRA vs. SIMPLE IRA Can Make Employee Retirement Saving More Effective
If you own a business, starting an IRA is one of the most effective ways you can help your employees save for retirement, as well as adding a huge potential draw for hiring talent. Many prospective employees will weigh the presence of an IRA retirement plan heavily in their consideration to accept a job offer from a potential employer. Knowing which one will be more beneficial to your business size and type can help you open an IRA that will serve you and your employees the best.
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Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on Forbes, The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.