The choice of retirement plan is vast and varied for small business owners and sole proprietors. From contribution limits to tax advantages and age requirements, determining which plan is right for you and your employees can be difficult.
In this article, I cover some of the advantages and disadvantages of two of the more popular options: a SEP IRA and a SIMPLE IRA. Other similar accounts not discussed here include: Solo 401(k) plans and SIMPLE 401(k) plans, among others.
Advantages of SEP
A Simplified Employee Pension IRA, or SEP IRA, is a low maintenance, easy to set up account that allows small businesses to help their employees save for retirement.
There are many advantages to SEP IRAs, especially for small businesses. One advantage is that this account is similar in many respects to the Traditional and Roth IRAs savers are more familiar with. The amount of paperwork and oversight required to open and operate this retirement plan is much less than a traditional 401(k) plan most large employers have.
The next advantage is investment options and flexibility within the SEP IRA itself. Unlike 401(k) plans that feature a limited and set menu of options, usually a variety of mutual funds, the funds inside SEP IRAs can be invested in a wide range of options such as individual stocks, bonds, options, ETFs, and more depending on the broker.
Another big advantage is taxes. The contributions for employees are tax deferred, meaning no tax is paid on the funds going in to the plan and the tax is deferred until the funds are withdrawn. The employer and employee pay no taxes on investment gains inside SEP IRA accounts.
Other benefits to a SEP IRA include:
- Higher contribution limits – up to 25% of an employee’s income
- Contributions can be variable from year to year to align with business results
- Reduced or no tax or government paperwork for employer to file
Advantages of SIMPLE IRA
A SIMPLE retirement plan is a “simplified” way for small employers to offer a retirement plan. Although we discuss the SIMPLE IRA here, a SIMPLE 401(k) is also an option.
The main advantage of a SIMPLE IRA versus a SEP IRA is that it gives employees more control because they are allowed to decide whether they want to contribute to the plan or not. The employer may make a contribution even if the employee does not contribute and if the employee does contribute, the employer may match up to 3% of the employee’s salary.
Employee contribution limits are generally higher for SIMPLE IRA plans versus Traditional and Roth IRAs. For 2016, the employee contribution limit for those under age 50 is $12,500 versus $5,500 for the other IRA types.
Other advantages to SIMPLE retirement plans include:
- No age limit
- Reduced paperwork and fees
- Immediate 100% vesting for all employees
- Tax deferral of employee contributions
Disadvantages of SEP
One huge disadvantage of the SEP IRA is the contribution rate the employer allocates to all employees, including themselves if they are also an employee in addition to being the employer, must be the same.
If you wanted to contribute more to a certain employee’s SEP IRA than the others for say, a family member or yourself, you would not be able to do so without giving the same bonus to all employees. This is what makes the SEP IRA a popular choice for entrepreneurs that operate a business by themselves as they have no other employees to consider when making contributions.
Another disadvantage to SEP IRAs is the account owner is not allowed to take a loan on his/her balance in the same way a 401(k) owner typically can. This is a feature of many 401(k) plans that allows the owner to borrow the money and pay themselves back over time. If the money is used for certain purposes, such as education, then the loan may have other advantages as well.
Further, employees can not voluntarily contribute to this account; they are at the mercy of the employer to fund it. Employees who want to contribute further must open their own individual IRA or use other means of saving for retirement.
Other disadvantages include:
- The employee must be 21 years of age
- The employee must have worked 3 of the last 5 years for the employer to be eligible
Disadvantages of SIMPLE
One disadvantage of the SIMPLE IRA is that employees must have earned $5,000 or more in the previous two years working at the employer offering the plan and must be expected to earn above that amount again for the current year in order to be eligible to participate.
While SIMPLE IRAs are great for small businesses, if a business is growing fast then businesses can run into issues using this type of plan. Businesses that have more than 100 employees are ineligible to use a SIMPLE IRA and once they cross that threshold the employer can no longer maintain the plan after two years.
Conclusion: SEP IRA vs SIMPLE IRA?
Overall, the choice between these two retirement plans depends on the type of business one owns, future growth plans for the business, and other factors.
SEP IRAs are cost affordable and make a good deal of sense for entrepreneurs or sole proprietors in medium to high income occupations such as a lawyers and consultants. The higher contribution limits and double tax advantage one receives from being both an employee and the employer can greatly reduce one’s tax burden.
SIMPLE IRAs are great for small businesses with 2-100 employees as they shift some freedom and incentive to the employee side and allow employees flexibility with their contributions. The downside is that the employer cannot be as flexible with their contributions through the business cycle and if the business is to grow beyond 100 employees, then this account will simply no longer be an option.
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