Both are employer-sponsored plans that provide employees a tax-advantaged way to save for retirement. Contributions grow tax-deferred until they are withdrawn in retirement. As their names imply, each is designed to be easily set up and cost-effective, particularly when compared to a 401(k) plan. Neither option requires annual IRS reporting.
Let's take a look at how each works and how they differ.
- SEP and SIMPLE IRAs were designed to make it easy for employers to set up tax-advantaged retirement plans for employees.
- Only employers can contribute to a SEP IRA.
- Businesses with fewer than 100 employees can set up a SIMPLE IRA, while any size business can set up a SEP IRA.
How SEP IRAs Work
A SEP IRA allows employers to adjust how much money is contributed, depending on the company's cash flow, making it a smart choice for businesses that have fluctuating seasons of good and bad income streams.
A SEP IRA is more flexible than a SIMPLE IRA with respect to annual contributions.
In 2020, employers can contribute up to $57,000 or 25% of the employee's compensation or (up from $56,000 in 2019), whichever is less.
Example of a SEP IRA
Joe works at Taylor's Body Shop, a company that offers a SEP IRA. Taylor's Body Shop can make large or small contributions to Joe's retirement, depending on its current financial status. Every employee receives the same percentage of contribution. Joe cannot invest his own income into the SEP.
How SIMPLE IRAs Work
A SIMPLE IRA helps small businesses create streamlined retirement accounts for their employees and themselves. SIMPLE stands for "Savings Incentive Match Plan for Employees." Only businesses with less than 100 employees can set one up.
A SIMPLE IRA has two contribution formulas that can be used. An employer can either:
- Match up to 3% of the employee's annual contribution, or
- Set up a non-elective 2% contribution of each employee's salary without requiring employee contributions.
In 2020, the contribution limit for employees is $13,500 (up from $13,000 in 2019). Employees 50 years and older can make an additional catch-up contribution of up to $3,000.
SIMPLE IRA Examples
Mary works at Micro Tech, a small business that provides SIMPLE IRAs to its employees. Micro Tech matches 3% of Mary's annual contribution. This year she did not contribute to her retirement, thus Micro Tech did not contribute to her SIMPLE IRA.
Janet works for LoveScope Investing. The company participates in a SIMPLE IRA and contributes a non-elective 2% to Janet's SIMPLE IRA annually. Janet did not contribute any of her $24,000 salary, but LoveScope Investing still had to invest $480 in her SIMPLE IRA.