SEP IRA vs. Qualified Retirement Plan: Which Is Better for a Small Business?

The SEP IRA is a great starter plan for a small business because it is easy to set up and maintain. Also, it provides funding flexibility with discretionary contributions. But sometimes, a small business needs more from its employees’ retirement plan, and this greater need might be met with a qualified retirement plan, or QRP. But not all plan features carry the same weight. Business owners might need to give and take by choosing the features that meet their greatest needs and giving up those of lower importance. The following are some features to consider.

This article is the third in a series that explains the features and benefits of popular retirement plans that small businesses can offer at low cost and the key questions business owners must answer to determine the most suitable.

Should Employees Share in Funding Their Retirement?

If an employer wants employees to share in the funding of their retirement accounts, the employer must choose a plan with a salary-deferral feature.

Since only employer contributions are allowed for SEP IRAs, an employer must choose a 401(k) plan to allow participants to make salary-deferral contributions to their accounts.

Participants may defer 100% of compensation up to $22,500 (the limit for 2023) to their 401(k) account. Participants age 50 and older as of the end of the year may make catch-up contributions of up to $7,500 (2023 limit) in addition to their regular salary-deferral contributions. These salary-deferral contributions can be made on a pretax basis, an aftertax basis to a designated Roth account available under the plan, or split between both.

Suitability Planning Tip: Savings incentive match plans for employees, or Simple IRAs, also allow salary-deferral contributions, allowing employees to defer 100% of their compensation up to $15,500 (2023 limit). Participants who are age 50 and older as of the end of the year may make catch-up contributions of up to $3,500 (2023 limit). An employer that places a high value on employees making salary-deferral contributions should compare a 401(k) with a Simple IRA. The Simple IRA contribution limits are lower but so are the administrative costs.

For more on Simple IRAs, see SEP vs. Simple IRAs: 5 Key Suitability Questions for Small Businesses.

Which Plan Allows for the Highest Contribution Limits

The maximum contribution amount that may be made to an employee’s SEP IRA is 25% of the employee’s wages.

For 2023, the maximum for a QRP 2023 is:

• For a defined-contribution plan, the lesser of (a) 100% of the employee’s compensation or (b) $66,000.
• For a defined-benefit pension plan, the amount needed to provide an annual benefit no larger than (a) $245,000 or (b) 100% of the participant’s average compensation for the highest three consecutive calendar years, whichever is less.

Using the national average salary of $57,200 per year, the maximum contributions for W-2 wage earners based on the type of retirement plan is:

Suitability Planning Tip: Calculate the contribution amount for all employees. This calculation will help to determine how much each employee may contribute and how much the employer would be required to contribute to the plan.

Consideration should also be given to the fact that SEP IRA contributions are discretionary, allowing the employer to choose whether to make contributions for a year. Employer contributions to pension plans are mandatory but can be discretionary for profit-sharing plans depending on how the plan is designed.

A discretionary feature is a saving grace for years when an employer cannot afford to make contributions.

Is a Vesting Schedule an Option?

A vesting schedule can help to reduce short-time employee turnover, thus saving on the cost of training new hires. See the Using a Vesting Schedule section in “How Retirement Plans Can Aid Your Client’s Small-Business Growth.”

Contributions to SEP IRAs are always immediately vested, which allows employees to withdraw those amounts at any time.

Employer contributions to a QRP can be subject to a vesting schedule.

Loans vs. Distributions

Withdrawals (distributions) may be made from QRPs only by employees who experience a qualifying event as defined by the plan’s terms. This restriction can be concerning for participants who need access to their savings during financially challenging times. However, a QRP can include a loan provision, allowing participants to borrow the lesser of $50,000 or (generally) 50% of the employee’s vested account balance. Loans may generally be repaid according to an amortization schedule within five years, or longer if the loan is used to purchase or build a primary residence for the participant.

Loans may not be made from SEP IRAs. However, participants may make distributions at any time.

If eligible, distribution amounts can be rolled over to an eligible retirement plan within 60 days of receipt, or longer if the account owner qualifies for a waiver of the 60-day deadline.

Administrative Costs and Responsibilities

A SEP IRA can be established by completing IRS Model Form 5305-SEP, which asks the employer only five questions. QRPs are more complex and require more information. Most financial institutions simplify the setup process by providing off-the-shelf kits for establishing and amending plans.

Administrative responsibilities for a SEP IRA can be limited to communicating the features, eligibility requirements, and plan contribution amounts, and operational requirements to employees. On the other hand, QRPs require nondiscrimination and top-heavy testing for plans that cover employees who are not highly compensated—in addition to those that apply to SEP IRAs.

QRPs must file Form 5500 Annual Return/Report of Employee Benefit Plan each year unless the QRP is a nonterminating plan that covers only the business owner and has a balance of $250,000 or less. Form 5500 is not filed for SEP IRAs.

For QRPs, other administrative requirements must be considered.

Choosing a Plan and Keeping Compliance

A business owner should work with an advisor to get a recommendation based on a suitability assessment. The assessment results should show the plan that fits based on the employer’s most desired features.

A reassessment should be done periodically to determine if the employer should switch to a different retirement plan.

An employer must ensure that its retirement plan maintains compliance with applicable requirements. Working with a plan administrator is an ideal compliance solution, but those who want to handle the process themselves may use the checklists provided by the IRS.

The features highlighted in this article are only a few that should be considered. My employer plan comparison table (free download) includes a comparison of other features and benefits.

Calculations are based on plans with the owner as the only participant. Results may differ for plans with multiple participants.

Denise Appleby holds webinars on the rules and regulations that govern IRAs and employer plans. Sign up to be notified about her webinar schedule.