SIMPLE IRA vs SEP IRA : find the differences
What are difference between SIMPLE IRA and SEP IRA? They are both employer sponsored plans and traditional IRAs. However, there are some differences.
What is a SIMPLE IRA?
Savings Incentive Match Plan for Employees (SIMPLE) IRA is an employer sponsored plan. It is a traditional IRA. A SIMPLE IRA allows employers to make contributions in retirement accounts for themselves and for their employees.
How does a SIMPLE IRA work?
Any small business with 100 employees or fewer can set up a SIMPLE IRA plan. The employer cannot have any other retirement plan. Generally, an employer cannot contribute to a SIMPLE IRA plan if the employer maintains another retirement plan.
The employers choose a specific SIMPLE IRA offered by financial institutions such as banks, insurance companies or other financial institutions which offer investment funds. Then, employees own and make their own decisions to invest amongst those investment funds. Employees are always 100% vested or have ownership of their SIMPLE IRA money.
Employers must make either a match-up contribution or non-elective contribution and employees may contribute as a salary deduction contribution. An employer is required to contribute each year, either:
- Match up contribution up to 3% of the employee’s annual compensation (not limited by any annual compensation), or
- Set up a non-elective 2% contribution of each employee’s compensation, up to the annual limit of $290,000 in 2021( $285,000 in 2020) without requiring employee contributions.
What is the SIMPLE IRA contribution limit?
The SIMPLE IRA contribution limit for employees is $13,500 for 2021 and 2020. Participants who are 50 years or above can make a SIMPLE IRA contribution of up to $16,500 ( including additional $3,000 catch-up contribution) in 2021 and 2020.
SIMPLE IRA examples
Situation 1: Andy and Taylor work for the 4U company. The 4U company has 65 employees. 4U has set up a SIMPLE IRA plan for its employees and will match its employees’ contribution up to 3% of each employee’s compensation.
Andy does not contribute to his SIMPLE IRA, so Andy does not receive any matching employer contribution. However, Taylor, whose annual compensation is $60,000 contributes 10% of her compensation ($6,000) to her SIMPLE IRA. Then, 4U’s match up contribution to Taylor’s compensation is $1,800 (3% of $60,000). As a result, the total contribution to Taylor’s SIMPLE IRA for the year is $7,800 ( Taylor’s $6,000 contribution plus 4U’s $1,800 matching contribution).
Situation 2: Andy and Taylor work for the 4U company. The 4U company has 65 employees. 4U has set up a SIMPLE IRA plan for its employees and will make a 2% non-elective contribution of each employee’s compensation.
Andy, whose annual compensation is $70,000, chooses not to contribute to his SIMPLE IRA. Andy will receive $1,400 ( 2% of $70,000) even though Andy does not contribute to his SIMPLE IRA. So, the total contribution to Andy’s SIMPLE IRA for the year is $1,400.
However, Taylor, whose annual compensation of $60,000 contributes 10% of her compensation ($6,000) to her SIMPLE IRA. 4U will contribute $1,200 (2% of $60,000). As a result, the total contribution to Taylor’s SIMPLE IRA for the year is $7,200 ( her $6,000 contribution plus 4U’s $1,200 contribution).
Can you get a loan from a SIMPLE IRA fund?
SIMPLE IRA loans are not permitted for participants.
Will you pay any tax on SIMPLE IRA withdrawals?
You can withdraw from a SIMPLE IRA fund, but the withdrawal must be included in your income. SIMPLE IRA withdrawals are subject to 10% additional tax if you are under 59 ½. Moreover, withdrawals made within the first 2 years of your participation, are subject to a 25% additional tax increasing from a 10% additional tax. Otherwise, SIMPLE IRA withdrawals are not subject to 10% or 25% additional tax if you are 59 ½ or above, disabled or deceased.
Can you rollover or transfer SIMPLE IRA to another IRA account?
During the first 2 year period when you start participating in a SIMPLE IRA plan, you can only transfer funds from SIMPLE IRA to other IRA accounts and 401K accounts, except Roth IRA. Non-qualified withdrawals must be included in your tax income and subject to 25% additional tax on the withdrawal amount.
After the 2-year period, you can rollover a SIMPLE IRA money into a Roth IRA. However, you must include it in your income.
What is a SEP IRA
Simplified Employee Pension (SEP) IRA is an employer sponsored plan. It is a traditional retirement IRA. A SEP IRA allows employers to make contributions in retirement accounts for themselves and for their employees. SEP IRA is a better option for companies whose businesses are cyclical and depend on different seasons. It is easy to set up and operate an SEP IRA.
How does a SEP IRA work?
Businesses of any size can set up a SEP IRA. Only employers can contribute and must contribute equally as the same percentage of compensation for all eligible employees. However, employers are not required to make SEP contributions every year.
The employers choose a specific financial institution which offers several investment funds for SEP. Then, employees make a decision to invest amongst those investment funds. Employees are always 100% vested or have ownership of all SEP IRA money.
What is the SEP contribution limit?
In 2021, employers can contribute up to $58,000 ( $57,000 in 2020) or 25% of the employee’s compensation, whichever is less. Note that elective salary deferrals and catch-up contributions are not permitted in SEP plans.
Will you have to pay tax on your SEP contribution?
Employer contributions to your SEP IRA are excluded from employee’s income and will not be included in the W-2, except if the contributions exceed applicable limits.
Employers can take a tax deduction for SEP IRA contributions. However, employers must deposit the contributions before the tax return filing date (excluding extensions) in order to take tax deduction on the year of contributions. The most tax deduction which employers can take, is the lesser of the employer’s contribution or 25% of compensations.
SEP IRA example
John works for an ABC restaurant. The ABC restaurant sets up a SEP IRA for employees. ABC has chosen a SEP IRA because its business can go up and down depending on seasons. ABC can make a bigger contribution for its employees in good times, and reduce the contribution in down times. The SEP financial institution that ABC has chosen for its employees, offers several investment funds. John decides to invest in 4 available funds. John cannot contribute. Only ABC can contribute.
What are the consequences if SEP contributions exceed limits?
Any SEP contributions exceeding limits can be withdrawn without penalty by the due date for filing your tax return. Otherwise, any contribution exceeding limits left in your SEP IRA account will result in adverse tax impact. Any exceeding contributions which are left in the employee’s SEP-IRA after the due date for filing tax return will be subject to a 6% tax on the employees’ IRAs, and a 10% tax on the employer’s excess contributions.
In addition, withdrawals on those contributions may pay tax as premature withdrawals.
Can you get a loan from SEP funds?
SEP IRA loans are not permitted for participants.
Will you pay any tax on SEP withdrawals
You can withdraw from a SEP IRA fund, but the withdrawal must be included in your income, except rollover. SEP IRA withdrawals are subject to 10% additional tax if you are under 59 ½.
SEP participation requirements
If you are not required to participate in a SEP, and you do not elect to participate, other employees may be prohibited from participating. If any eligible employees do not participate, and the employer still establishes a SEP for the remaining employees, it could result in adverse tax consequences for the participants.
Any employee who has worked for an employer in any 3 of the last 5 years must be included in the employer’s SEP IRA plan. SEP participant eligibility requirements can be less restrictive and variable depending on the employers’ rule flexibility.
Can you rollover or transfer SEP IRA to another IRA account?
You can rollover SEP IRA to another IRA without penalty if you rollover only once in any 1 year period. When you withdraw or receive funds from your SEP-IRA, within 60 days of receipt, you have to put those funds in the same or another IRA to avoid penalty.
However, there are no limitations on the number of times you transfer if you arrange to have these funds transferred between the trustees or the custodians so that you do not have possession of the funds.
SARSEPS (established before 1997)
Salary Reduction Simplified Employee Pension (SARSEP) plans were established before 1997. SARSEP participants were entitled to make elective salary deferral contributions. SARSEP elective deferral contributions are limited to the lesser of $19,500 in 2020 and 2021 or 25% of participants’ compensation. However, catch-up contributions are not subjected to these limits.
SIMPLE IRA vs SEP IRA
| 2021 | SIMPLE IRA | SEP IRA |
| Availability for Business | 100 employees or fewer | Any size of businesses |
| Contribution | Employer contribution is a must Employees may elect to contribute | Employer contribution only Employers are not required to contribute to SEP IRA every year. |
| Contribution limit | $13,500 if you are under 50 $16,500 (including $3,000 catch-up contribution) if you are 50 and above | The lesser of $58,000 ($57,000 in 2020) Or 25% of the employee’s compensation Catch-up contribution does not apply |
| Pre-retirement withdraw | Subject to 10% additional tax if you are under 59 ½. Moreover, withdrawals made within the first 2 years of your participation, are subject to a 25% additional tax increasing from a 10% additional tax. Not subject to 10% or 25% additional tax if you are 59 ½ or above, disabled or deceased. | Subject to 10% additional tax if you are under 59 ½. Not subject to 10% additional tax if you are 59 ½ or above, disabled or deceased. |
| Requirement minimum distribution (RMDs) | Required if you turn 72 (70 ½ if you were born before July 1, 1949). | Required if you turn 72 (70 ½ if you were born before July 1, 1949. |
| Tax on RMD | At your taxable income rate, except any portions are already taxed before | At your taxable income rate, except any portions are already taxed before |
| Loans | Not permitted | Not permitted |
| Ownerships | Employee is alway vested 100% | Employee is alway vested 100% |
Questions and Answers – SIMPLE IRA vs SEP IRA
1. Can you contribute to your Roth IRA If you participate in SEP IRA?
Yes, you can receive employer contributions to your SEP IRA and make your own contribution to your Roth IRA. Your employer contribution to your SEP does not affect the amount of your own contribution to IRA.
SEP IRA is a traditional IRA, so you can make an annual IRA contribution to this traditional IRA, rather than operating another IRA account. Note that your own contribution to the 2021 IRA contribution limit is $6,000 if you are under 50 and $7,000 if 50 and above.
For example:
John, 35 years old, works for an ABC company. In 2021, ABC may contribute $4,000 to John’s SEP IRA as ABC’s retirement term. John is also permitted to make his own contribution to his IRA account at ABC. So, John decides to contribute $3,000 to his IRA account. In addition, John has a Roth IRA account in which he can contribute another $3,000 into this Roth IRA account.
2. Are employers required to contribute to the SEP IRA every year?
No, employers are not required to contribute to SEP IRA every year. However, if employers do contribute to SEP IRA, the contribution must be made to all eligible employees for SEP IRA.
3. Must your employer contribute the same percentage of compensation to all eligible participants?
Yes, your employer must contribute the same percentage of each participant’s compensation.
4. Can you leave SEP IRA untouched If you leave the company or the company is bankrupt?
Yes, you can leave SEP IRA untouched if you leave the company or the company is bankrupt. Or you can rollover or transfer your SEP IRA to your Roth IRA account.
5. May participants (employees) elect not to make their own contribution to a SIMPLE IRA?
Participants may elect not to make their own contribution to a SIMPLE IRA. Then, those participants will not receive an employer matching contribution for the year. However, they will receive an employer non-elective contribution if the plan provides it.
6. Can employers terminate, decrease or increase the matching contributions to a SIMPLE IRA plan in the middle of the year?
Employers cannot terminate, decrease or increase the matching contributions to a SIMPLE IRA plan in the middle of the year. The employer must make the contributions to their employees as the SIMPLE IRA plan term.
7. Do employers have to make a contribution to a SEP IRA (or SIMPLE IRA) for a participant who is not employed on the last day of the year?
Yes, all eligible participants must have a share in a SEP IRA (or SIMPLE IRA) contribution. Employers have to make a contribution for a participant who is not employed on the last day of the year. Those eligible participants include those who die or leave the company before the contribution is made for the year.
Sources
Internal Service Revenue. Choose a Retirement Plan : SEP IRA Plan
https://www.irs.gov/retirement-plans/choosing-a-retirement-plan-sep. Accessed May 27, 2021
Internal Service Revenue. Choose a Retirement Plan : SIMPLE IRA Plan
https://www.irs.gov/retirement-plans/choosing-a-retirement-plan-simple-ira-plan. Accessed May 27, 2021
Internal Service Revenue. SEP Plan FAQs.
https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-seps. Accessed May 27, 2021
Internal Service Revenue. SIMPLE Plan FAQs.
https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-simple-ira-plans. Accessed May 27, 2021
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