SIMPLE IRAs vs. SEP IRAs: What is the Difference?
The primary difference between a SIMPLE IRA and a SEP-IRA are who is allowed to fund the retirement accounts and the contribution limits. Both a SIMPLE IRA and a SEP-IRA are tax-deferred individual retirement accounts offered primarily by small business owners to their employees or for self-employed individuals to use to save for their own retirement. Who doesn’t want more money for retirement?
SIMPLE IRA, which stands for Savings Incentive Match Plan for Employees Individual Retirement Account, provides a way for small business owners to set up a retirement account for both their employees and themselves. It works like a traditional IRA but has a higher contribution limit. If you do not have the ability to set up a 401(k), the business owner can set up a SIMPLE IRA.
Income Requirements. To qualify, an employee needs to have earned at least $5,000 from the employer setting up the SIMPLE IRA. Also, the employee needs to expect to earn at least $5,000 in the calendar year to be eligible to participate in the plan.
Employee Contributions. Employees can make contributions directly from their pay, using pre-tax dollars. This works similarly to elective deferrals to a 401(k) made by employees. Although employees do not have to fund their SIMPLE IRA, they cannot decline the retirement account. There is no opt out option. However, if your employer is contributing to it for you, why would you want to pass up free money for retirement!
Employer Contributions. Employers have the flexibility to decide how they want to contribute to employees’ accounts, if at all. They can either match employees’ contributions or make a non-elective contribution, regardless if the employee contributes any funds or not.
Contribution Limits. The contribution limit for 2020 is $13,500. There is an allowed catch-up contribution limit of $3,000, which allows people aged 50 and older to contribute a total of $16,500 ($13,500 + $3,000) for 2020.
Tax Benefits. Employers and employees can use pre-tax dollars to fund SIMPLE IRAs. This means the employer and employee does not have to pay taxes on the money deposited into SIMPLE IRAs. This makes it a win-win for both the employer and employees. When the money is withdrawn during retirement, it is taxed. If it is withdrawn early, tax penalties may apply.
SEP-IRA, which stands for simplified employee pension, provides a way for self-employed individuals and small business owners to save for retirement for their employees and themselves. There are several differences between SIMPLE and SEP-IRAs. However, the main differences are employees, who have SEP-IRAs offered, cannot contribute to the retirement plan themselves and the contribution limit for SEP-IRAs can be much higher than SIMPLE IRAs.
Income Requirements. Because the contribution amount is based on a percentage of the employee’s salary and capped at a certain amount (see Contribution Limits below), the employee does not have to earn a certain amount to qualify.
Employee Contributions. Because employees cannot contribute to SEP-IRAs, they do not have to contribute anything to be eligible. Only the employer can contribute to the SEP-IRA.
Contribution Limits. The employer can make contributions up to 25% of an employee’s salary or up to $57,000 in 2020. All of the employees of the business, including the owner, must receive the same contribution percentage. For example, if the employer decides to contribute 6% of an employee’s salary, they must do it for everyone and cannot offer select employees (including themselves) a higher percentage.
Tax Benefits. Employers can use pre-tax dollars to fund SEP-IRAs. This means the employer does not have to pay taxes on the money deposited into SEP-IRAs either for their employees or themselves. This makes it a win-win for both the employer and employees. When the money is withdrawn during retirement, it is taxed. If it is withdrawn early, tax penalties may apply.
The Bottom Line
Depending on what an employer is wanting to accomplish, both SIMPLE and SEP-IRAs provide ways for employees to build a tax-deferred savings for retirement.
SIMPLE IRAs provide a great way for both employers and employees to contribute to the retirement account for the employee. The total allowable contribution amount for 2020 is $13,500 for people under age 50 and $16,500 for people age 50 and above.
SEP-IRAs provide a great way for employers to contribute up to 25% of an employee’s salary to a tax-deferred retirement account (a maximum of $57,000 in 2020). The big catch is the employer has to contribute the same percentage for all employees (including themselves).
Contact the tax professionals at Gudorf Tax Group to schedule an appointment to review how saving for retirement will affect your taxes, so you can make a wise decision to max out your retirement contributions and tax savings.