SEP vs. SIMPLE IRA: What’s the difference?

Small business owners and self-employed people enjoy several options when it comes to saving money for retirement. Among the most common routes are an SEP IRA or a SIMPLE IRA.

Before choosing an SEP IRA or a SIMPLE IRA as a savings vehicle for retirement, be sure to examine all the types of retirement funds available. If you’ve settled on an SEP IRA or a SIMPLE IRA, look at which types of employers or people are eligible to participate, what the contribution limits are and what the tax implications are.

Read on to learn more about SEP and SIMPLE IRAs.

Key takeaways

• SEP IRAs are available to employers of any size, while SIMPLE IRAs are limited to employers with 100 or fewer employees.

• Income requirements for SEP IRAs are slightly less complex than they are for SIMPLE IRAs.

• SEP IRAs come with higher annual contribution limits than SIMPLE IRAs do.

• Only an employer can make contributions to an SEP IRA, but a SIMPLE IRA lets employers and employees make contributions.

• An employer is required to make contributions to an SEP IRA, but an employer has the freedom to make contributions to a SIMPLE IRA or no contributions at all.

A Simplified Employee Pension (SEP) plan lets an employer put aside money in a traditional IRA for both the employer and their employees. The IRS permits contributions to an SEP IRA of up to 25% of each employee’s pay.

SEP IRAs are available to employers of any size, including businesses, self-employed people, tax-exempt organizations and government entities. An SEP IRA can be set up as a traditional IRA but not as a Roth IRA. However, it can be converted to a Roth IRA.

Benefits of an SEP IRA include:

• Ease of establishing and maintaining it.

• Tax-deferred growth of earnings.

• Flexibility of annual contribution amounts.

• Generous contribution amounts.

• Immediate vesting of tax-deductible contributions.

A Savings Incentive Match Plan for Employees (SIMPLE) IRA is a retirement savings option available to employers with up to 100 employees. Both employers and employees can contribute to a SIMPLE IRA. It can be created only as a traditional IRA, not as a Roth IRA.

Employees decide each year how much of their pay they want to go toward their SIMPLE IRA accounts, and their employer must match these contributions. An employee’s contributions come out of their paycheck before federal taxes are paid.

Benefits of a SIMPLE IRA include:

• Ease of establishing and maintaining it.

• Mandatory contribution matches by employer.

• Immediate vesting of employer’s contribution matches.

• Potential tax credits for employers and employees.

• Tax-deferred growth of money until it’s withdrawn.

Both SEP and SIMPLE IRAs offer ways for people to save money for retirement. However, there are some key differences between SEP and SIMPLE IRAs:

• SEP IRA: Available to any business owner, employer, self-employed person or freelancer.

• SIMPLE IRA: Available to any employer with 100 or fewer workers, including small businesses, self-employed people, tax-exempt organizations and government entities.

• SEP IRA: Employers only.

• SIMPLE IRA: Employers and employees.

• SEP IRA: An employer must make contributions according to IRS guidelines.

• SIMPLE IRA: Employers aren’t required to make contributions.

• SEP IRA: Up to 25% of employee’s total compensation or $66,000, whichever is less.

• SIMPLE IRA: Either a dollar-for-dollar match of employee contributions up to 3% of an employee’s compensation or 2% of each employee’s compensation. The compensation limit for 2023 is $330,000.

• SEP IRA: $6,500. Or $7,500 for an employee who is at least 50 years old. The extra $1,000 is a catch-up contribution.

• SIMPLE IRA: $14,000. Or $17,000 for an employee who is at least 50 years old. The extra $3,000 is a catch-up contribution.

• SEP IRA: Up to 20% of net income.

• SIMPLE IRA: Either a dollar-for-dollar match of employee contributions up to 3% of an employee’s compensation or 2% of each employee’s compensation. The compensation limit for 2023 is $330,000.

• SEP IRA: Subject to regular income tax on withdrawals starting at age 59 1/2. Subject to a 10% penalty on withdrawals made before age 59 1/2.

• SIMPLE IRA: Subject to regular income tax on withdrawals starting at age 59 1/2. Subject to a 10% penalty on withdrawals made before age 59 1/2 unless a tax exemption applies. Subject to a 25% penalty on withdrawals made within the first two years of the plan unless a tax exemption applies.

Although SEP and SIMPLE IRAs differ in many ways, they also share some things in common, such as:

• Neither plan can be set up as a Roth IRA.

• Contributions to SEP and SIMPLE IRAs are made with pretax dollars.

• Money grows on a tax-deferred basis. Regular income taxes aren’t paid until withdrawals are made.

• Withdrawals before age 59 1/2 are subject to tax penalties.

• Employer contributions to both types of plan qualify for tax deductions.

While there is really no “right” choice between an SEP IRA and a SIMPLE IRA, there are some factors that might tip the balance toward one option over the other. They include:

• SEP IRAs are available to a broader array of employers than SIMPLE IRAs are.

• SEP IRAs offer higher annual contribution limits than SIMPLE IRAs do.

• A SIMPLE IRA enables both employers and employees to make contributions, while only an employer can make contributions to an SEP IRA.

• Income requirements for SEP IRAs are a bit less complicated than they are for SIMPLE IRAs.

• Employer contributions must be made to an SEP IRA, while an employer can make or not make contributions to a SIMPLE IRA.

• SIMPLE IRAs come with stiffer tax penalties for early withdrawals than SEP IRAs do. While both plans are subject to a 10% tax penalty before age 59 1/2, an employee can face a 25% penalty if they take out money within two years of joining a SIMPLE plan.

An employer can’t maintain both an SEP IRA and a SIMPLE IRA. Therefore, an employee can’t belong to an SEP IRA and a SIMPLE IRA with the same employer. However, if someone has two employers, they can sign up for one type of IRA with one employer and the other type of IRA with the other employer.

Aside from an SEP IRA or a SIMPLE IRA, options for business owners or self-employed workers include a traditional IRA, Roth IRA and solo 401(k).

A traditional IRA enables a business owner or self-employed person to stash money for retirement on a pretax basis. The money grows on a tax-deferred basis; withdrawals are subject to taxes.

A Roth IRA lets a business owner or self-employed person set aside money for retirement on an after-tax basis. Money sitting in a Roth IRA isn’t taxed, and qualified withdrawals are tax-free.

A solo 401(k) is designed for a self-employed person or small business owner who has no employees (except their spouse). Contributions can be made as both an employer and employee. The tax situation for a solo 401(k) depends on whether it’s a traditional 401(k) or Roth 401(k).

Either an SEP IRA or a SIMPLE IRA can be an attractive choice for a retirement plan, depending in large part on the size of your business. Before setting up either type of IRA, consider the pros and cons of each. Factors to take into account include the tax implications, contribution limits and withdrawal penalties.

Once you’ve decided on the type of retirement account that best suits your needs, you may be ready to begin making contributions. But you might not know how much you should be chipping in. Check out Capital One’s guide on how much you need to retire.