SEP IRA VS. SIMPLE IRA

In the first installment of our three-part series about retirement plans available to small businesses, I talked about the difference between Traditional and Roth IRAs. In this second installment, I’ll discuss SEP and SIMPLE IRA’s.  The third and final installment will discuss 401(k) options for small businesses.

Simplified Employee Pension (SEP) IRA

A SEP IRA is funded by a tax-deductible contribution made by the employer to the accounts of qualifying employees.  Employees themselves, do not make contributions to a SEP IRA.  

Employer contributions to a SEP IRA are elective.  The employer is not required to make contributions in any given year, which would be a good thing for a year with low income.   Contributions can be made for the tax year up to the due date of the tax return, including extensions.  This means you have plenty of time after your tax year closes to figure out how much, if anything, you can afford to contribute.  In 2021, contributions to a SEP IRA can be for up to 25% of each eligible employee’s compensation, to a maximum of $58,000.

Contributions to an employee’s SEP IRA account must generally be an equal percentage of compensation for all employees.  For example, if an employer elects to make a 10% SEP contribution, they must contribute 10% of each qualified employee’s own wages to the employee’s SEP account.  Under these circumstances, if Sam earned $5,000 during the year, and Jane earned $6,000, the employer would contribute $500 and $600 to their respective accounts.

At a minimum, qualified employees must include those who meet the following criteria, although the employer is allowed to set less restrictive qualifications if desired:

  • The employee attains the age of 21 during the year, and
  • The employee worked in the employer’s business in three of the last five years, and
  • The employee received at least $650 in compensation from the employer’s business during the tax year

Savings Incentive Match Plan for Employees (SIMPLE) IRA

A SIMPLE IRA allows employees to contribute to their own retirement accounts.  Employers can elect to either:

  1. Make a dollar-for-dollar match of employee contributions up to 3% of their annual compensation, or
  2. Make a 2% contribution to the account of all eligible employees, whether they contribute or not.

Employees may contribute up to $13,500 in 2021.  If the employee participates in any other deferred compensation retirement plans during the year, their entire combined contributions cannot exceed $19,500.  (Additional $3,000 catch-up contributions can be made by participants that are 50 years of age or older.)

Any employee who earned at least $5,000 of compensation in two previous years, and expects to earn $5,000 in the current year, is a qualified employee eligible to participate in the SIMPLE IRA.  The employer must deposit their required contributions before the due date of the tax return (including extensions).

The following table provides a summary of the SEP and SIMPLE IRAs

Simplified Employee Pension (sep) ira Savings incentive match plan for employees (simple) ira
WHO CAN PARTICIPATE? A SEP IRA account must be created for each eligible employee.  Eligible employees are at least 21 years of age, have been employed by your business for at least 3 of the last 5 years, and receive at least $600 in compensation from you. Any employee who received at least $5,000 in compensation during any 2 years preceding the current calendar year, and is reasonably expected to receive at least $5,000 during the current calendar year is eligible to participate.  Must have fewer than 100 employees.
WHO MAY BE EXCLUDED? Unionized employees covered by a retirement plan that was bargained for in good faith, and nonresident aliens who have received no U.S. sourced wages. Unionized employees covered by a retirement plan that was bargained for in good faith, and nonresident aliens who have received no U.S. sourced wages.
HOW IT WORKS Employees do not contribute to a SEP IRA.  Employers contribute to their employee’s SEP IRA accounts based on a percentage of income.  The same percentage applies to all employees, but the employer is not required to make a contribution every year.  In years when profits are low, for example, the employer would not be required to make a contribution. Eligible employees can elect to have contributions to a SIMPLE IRA withheld from wages on a pre-tax basis.  (FICA taxes are NOT exempt.)  The employer chooses to either match employee contributions up to 3% of their salary, or they can elect to contribute 2% to the accounts of ALL eligible employees, whether the employee contributes to their own account or not. 
CONTRIBUTION LIMITS The maximum that can be contributed in 2021 is 25% of the employee’s salary, up to $58,000. Employees can contribute up to $13,500 in 2021.  Employees who reach age 50 by the end of the calendar year can elect to defer an additional $3,000.
CAN CONTRIBUTIONS BE MADE TO A ROTH IRA? No, but contributions to a SEP IRA won’t affect the amount an individual can contribute to a Roth or traditional IRA. No, but contributions to a SIMPLE IRA won’t affect the amount an individual can contribute to a Roth or traditional IRA.
TIMING OF CONTRIBUTIONS To deduct contributions for a year, you must make the contributions by the due date (including extensions) of your tax return for the year You can deduct contributions for a particular tax year if they are made for that tax year and are made by the due date (including extensions) of your federal income tax return for that year.