The SEP IRA and SIMPLE IRA are both retirement plans available to business owners. They offer higher contribution limits than a Roth or traditional IRA, and are easy to set up and maintain compared to a regular 401k plan.
However, the two accounts differ in objective and function. The SEP IRA is more advantageous for business owners and the SIMPLE IRA is more advantageous for employees. The SEP IRA is closer in function to a solo 401k and the SIMPLE IRA is more similar to a regular 401k plan.
SEP IRA vs SIMPLE IRA: An overview
| Feature | SEP IRA | SIMPLE IRA |
|---|---|---|
| 2022 Contribution Limit | $61,000 | $14,000 |
| 2023 Contribution Limit | $66,000 | $15,500 |
| Catch-up contributions | No | Yes – $3,000 for 2022 and $3,500 for 2023 |
| Roth option | No | No |
| Employees can contribute? | No | Yes |
| Employer contributions | Yes, optional each year | Yes, mandatory each year |
| Withdrawal age | 59½ | 59½ |
| Withdrawal tax | Taxed as regular income | Taxed as regular income |
| RMD | Yes | Yes |
How a SEP IRA works
A SEP IRA can supercharge a business owner’s ability to save for retirement. With potential tax deductions up to $61,000 for 2022 and $66,000 for 2023, the SEP IRA is a popular retirement plan option for business owners with a handful of employees. Unlike a SIMPLE IRA, only employers can contribute to a SEP IRA – employees cannot make contributions to a SEP IRA and can only receive contributions from their employer. Due to the equal percentage contribution rule (explained further down below), a SEP IRA is best for business owners with only a few employees.
Eligibility: Any business owner, with or without employees, can set up and contribute to a SEP IRA.
Contribution limits: The contribution limit is $61,000 for 2022 and $66,000 for 2023. There are no catch-up contributions for a SEP IRA.
Contribution rules: Only employers can contribute to a SEP IRA, and contributions are calculated using 25% of compensation if the business is incorporated, and 20% of compensation if the business is not incorporated.
Tax deductions: A SEP IRA has no Roth option. All contributions are made with pre-tax dollars (income that hasn’t been taxed yet), and get deducted from your taxable income for the year. Money in your SEP IRA gets invested and any earnings are tax-deferred until withdrawals are made in retirement.
Withdrawal age: You can start to take qualified distributions when you reach the age of 59½. Any earlier withdrawals are hit with a 10% penalty plus income taxes on the amount drawn.
Withdrawal taxes: Since a SEP IRA can only be funded with pre-tax income, you’ll owe regular incomes taxes when you take distributions in retirement.
Required minimum distributions (RMD): A SEP IRA has required minimum distributions. Once you reach the age of 72, you must start taking at least a minimum amount of distributions from your account each year, until emptied. The RMD can be calculated using this table.
Investment options: Funds in a SEP IRA can be invested in traditional assets like stocks, bonds, mutual funds, and ETFs.
Equal percentage contributions for employees
Most business owners that set up a SEP IRA will do so with their own retirement savings in mind, since the $61,000 contribution limit is 10x higher than an IRA.
A SEP IRA can start to get expensive when you have too many employees due to the equal percentage contribution rule. If you make a contribution to your SEP IRA, you must also make an equal percentage contribution for every eligible employee’s SEP IRA. For example, if you contribute 10% of your compensation to your SEP IRA, you must also contribute 10% of every eligible employee’s compensation into their SEP IRAs.
Employees cannot contribute to a SEP IRA and can only receive contributions from their employer. All contributions made by the employer are immediately 100% vested for receiving employees.
What counts as an eligible employee? Any employee who is at least 21 years of age, has worked for the business for at least 3 out of the last 5 years, and earned at least $650 in compensation for 2022 and $750 in compensation in 2023.
Contributions are not mandatory each year: Unlike a SIMPLE IRA, a business owner sponsoring a SEP IRA for their employees can choose to skip contributions if they have a down year.
How a SIMPLE IRA works
A SIMPLE IRA is more like a cheaper, simpler alternative to a regular 401k plan. It’s mainly set up by business owners with dozens of employees (but not over 100) to offer them retirement benefits without the costs and maintenance complexities that come with a regular 401k plan. Unlike a SEP IRA, employees are allowed to make contributions to their own plans, as well as receive mandatory contributions from their employer.
Eligibility: Any business owner with under 100 employees can set up and contribute to a SIMPLE IRA.
Contribution limits: The contribution limit is $14,000 for 2022 and $15,500 for 2023. Unlike a SEP IRA, a SIMPLE IRA has catch-up contributions. If you’re at least 50 years of age, you can contribute an additional $3,000 in 2022 and an additional $3,500 in 2023.
Contribution rules for employees: Employees can make contributions to their own accounts as pre-tax elective deferrals, which get deducted from their taxable income, and also receive mandatory contributions from their employer.
Contribution rules for employers: Unlike a SEP IRA, employers must make contributions to their employees’ SIMPLE IRAs each year, and can choose from one of two options:
- Make non-elective contributions equal to 2% of an employee’s compensation based on a maximum salary of $305,000 in 2022 and $330,000 in 2023.
- Make matching contributions up to 3% of an employee’s compensation, not limited by any compensation limits.
All employer contributions made to employee SIMPLE IRAs are immediately 100% vested.
Tax deductions: A SIMPLE IRA also has no Roth option. All contributions are made with pre-tax dollars (income that hasn’t been taxed yet), and get deducted from your taxable income for the year. Money in your SIMPLE IRA gets invested and any earnings are tax-deferred until withdrawals are made in retirement.
Withdrawal age: Same as a SEP IRA, you can start to take qualified distributions when you reach the age of 59½. Any earlier withdrawals are hit with a 10% penalty plus income taxes on the amount drawn. If you’re making an early withdrawal and your account is under 2 years old, you’ll receive an additional 15% penalty applied on top.
Withdrawal taxes: Since a SIMPLE IRA can only be funded with pre-tax income, you’ll owe regular incomes taxes when you take distributions in retirement.
Required minimum distributions (RMD): A SIMPLE IRA also has required minimum distributions. Once you reach the age of 72, you must start taking at least a minimum amount of distributions from your account each year, until emptied. The RMD can be calculated using this table.
Investment options: Funds in a SIMPLE IRA can be invested in traditional assets like stocks, bonds, mutual funds, and ETFs.
Mandatory employer contributions
With a SEP IRA, you can choose how much you want to contribute each year, and even choose to skip contributions altogether if the business is having a down year. With a SIMPLE IRA, annual contributions are mandatory for employers.
Depending on the contribution option you choose, employees can choose to make contributions to their own account (to receive a matching contribution up to 3% of compensation). If non-elective contributions were chosen, employees could choose not to make any contributions to their own accounts and still receive employer contributions equal to 2% of their compensation.
Considerations when choosing between a SEP IRA or SIMPLE IRA
As outlined, the goals with a SEP IRA and SIMPLE IRA are quite different due to the dissimilar contribution rule and limits.
- A SEP IRA is best for business owners with just a few employees due to the equal percentage contribution rule.
- A SEP IRA allows business owners to skip contributions if the business is having a down year, while contributions are mandatory with a SIMPLE IRA.
- A SIMPLE IRA is better for businesses with steady profits. A business with unsteady profits can benefit from a SEP IRA since the business owner can choose to make smaller than normal contributions for the year, or skip them altogether.
- A SIMPLE IRA is better for larger businesses with up to 100 employees. While only employers can contribute to a SEP IRA, both employers and employees can contribute to a SIMPLE IRA.
- While self-employed business owners with zero employees can set up a SEP IRA or SIMPLE IRA, a solo 401k offers more tax benefits than either of them.
- A solo 401k is very similar to a SEP IRA, but also comes with a Roth options, higher contribution limits if over 50 years of age, and the ability to invest in any asset class, including alternative investments.