SEP vs. SIMPLE IRAs: 5 Key Suitability Questions for Small Businesses

Cost and administrative complexity are two of the most frequently cited reasons small businesses give for not offering a retirement plan. But the Simplified Employee Pension (or SEP) IRA and the Savings Incentive Match Plan for Employees (or SIMPLE) IRA are designed to alleviate these concerns. They are easy to establish, administer, and explain. And there is little to no cost for administration. For employers attracted by the simplicity of these plans, the challenge is to choose which is more suitable. These five questions can be an excellent start to providing the answer.

This article is the second in a series. The series of articles 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 for their business.

1. Is the Employer Eligible?

Any business can adopt a SEP IRA as there are no restrictions. But for SIMPLE IRAs, there is a 100-employee limit.

Under the 100-employee limit, the employer must have no more than 100 employees who earned $5,000 or more from the employer during the preceding calendar year unless an exception applies. All employees must be counted for this purpose, including those not eligible to participate in the SIMPLE IRA plan. Therefore, a business can have over 100 employees and still be eligible to maintain a SIMPLE IRA for a year, because only 100 or fewer employees earned $5,000 or more from the employer during the preceding calendar year.

Caution: Employers with ownership in more than one business might need to include those businesses when determining which employees must be covered under their retirement plan. In such cases, the employer might need to hire an attorney specializing in this area.

‘Only Plan’ Requirement for SIMPLE IRAs

The SIMPLE IRA must be the only plan maintained by the employer unless an exception applies. For instance, the employer may maintain another retirement plan for employees who are covered under a collective bargaining agreement and are not covered under the SIMPLE IRA.

The winner of this feature: The SEP IRA is the winner with no limit on the number of employees. However, this would be a nonissue for a SIMPLE IRA if the employer meets the 100-employee limitation.

2. Has the Adoption Deadline Passed?

An employer may set up a retirement plan for a year only if it is done by the applicable deadline.

For SIMPLE IRAs, the deadline is October 1 unless an exception applies. If the businesses come into existence after Oct. 1, an exception allows that employer to establish the plan as soon as administratively feasible. If the employer previously maintained a SIMPLE IRA, the deadline is January 1.

For SEP IRAs, the deadline is the employer’s tax filing due date, including extensions.

The winner of this feature: The SEP IRA is the winner because the extended deadline gives the employer more time to decide whether to establish and fund the plan for the year. The employer’s tax advisor would have fully assessed their profit and loss status by then, and determined how much they can afford to contribute for the year.

With the SIMPLE IRA, the employer must commit to contributions for a year 60 days before that year starts. While the contribution percentage is small (it can be as low as 1% of compensation), it can be a lot for a business with losses instead of profits.

3. How Many Employees Must be Covered?

The cost of funding a plan is one factor that often determines which plan an employer chooses. And the number of employees that must be covered usually determines the employer’s total contribution for a year.

For a SEP IRA, any employee who worked for the employer for three of the five years that precede the year for which the contribution is made must share in contributions made for the year. For example, if the employer is funding the SEP IRA for 2024, any employee who worked for any three years from 2019 to 2023 must be covered for 2024.

For SEP IRAs, a year of service is any period, however short. In addition, employees under age 21 can be excluded from the plan.

For SIMPLE IRAs, all employees who earned at least $5,000 in compensation from the employer during any two years that precede the year for which the SIMPLE plan is being maintained and are reasonably expected to receive at least $5,000 in the calendar year for which the plan is being maintained are eligible to participate in that employer’s SIMPLE IRA.

There is no age requirement for SIMPLE IRAs.

The winner of this feature: The SEP IRA is the winner for an employer who wants to exclude as many employees as possible because employees can be required to provide longer service before becoming eligible. This service requirement can encourage employees to stay with the company longer to become eligible for employer contributions. Additionally, if the employees are under 21, the employer can elect to have them excluded from the plan.

PS: Employers may elect to have less restrictive eligibility requirements. And employees covered under collective bargaining agreements and nonresident aliens who receive no compensation from the employer can be excluded from either plan.

4. How Important is Maximizing Contributions?

A comparison should be done for an employer who wants to contribute the most amount possible. This maximum amount is based on the compensation employees received for the year.

For SEP IRAs, the maximum contribution is 25% of W-2 wages. Only employer contributions are allowed. The compensation cap ($335,000 for 2023) applies to the calculation of contributions.

For SIMPLE IRAs, the maximum contribution is:

• Salary deferral: 100% of compensation up to $15,500. Participants aged 50 and older may make a catch-up contribution of up to $3,500.
• Employer Contribution: A matching contribution of up to 3% of compensation for each employee who makes a salary deferral contribution.

The compensation cap applies to a SIMPLE only if the employer elects to make a nonelective contribution (limited to 2%) instead of a matching contribution.

The winner of this feature: This depends on the compensation amount. The following is a comparison based on attaining age 50 and compensation for the year.

Notes:

• They both receive the same compensation amount. But Jack is eligible to make a catch-up contribution to the SIMPLE IRA because he will be at least age 50 by the end of the year.
• The maximum compensation that counts for the SEP IRA is $330,000. And contributions to the SEP are limited to the lesser of 25% of compensation or $66,000 (2023 limit). Hence, while 25% of $400,000 is $82,500, it is capped at $66,000.
• The SEP is funded only with employer contributions. The SIMPLE is funded with a salary deferral of $15,500 (and catch-up contributions of $3,500 for Jack) plus a $1-for-$1 matching contribution of up to 3% of $400,000.

Notes:

• They both receive the same compensation amount. But Dahlia is eligible to make a catch-up contribution to the SIMPLE IRA because she will be at least age 50 by the end of the year.
• Contributions to the SEP are limited to $7,500 (the lesser of 25% of compensation or $66,000 (2023 limit).
• The SEP is funded only with employer contributions. The SIMPLE is funded with a salary deferral of $15,500 (and catch-up contributions for Dahlia) plus a $1-for-$1 matching contribution of up to 3% of $30,000.
• The calculation of contributions for self-employed (unincorporated) business owners is more complex than for W-2 wages. Chapter 5—Table and Worksheets for the Self-Employed in Publication 560 or the Plan Contributions Calculator on my website can be used to calculate these amounts.

5. Is flexibility with when and how much to contribute an important feature?

Small businesses, particularly those without an established history of profitable years, can find it helpful if they are not required to contribute every year.

The SEP IRA offers this flexibility as contributions are discretionary, allowing the employer to choose to make contributions from zero to 25% of compensation for a year.

For the SIMPLE IRA, contributions can be mandatory.

• If the employer chooses to make a matching contribution, employer contributions must be made for eligible employees who make salary deferral contributions.
• If the employer chooses to make a nonelective contribution, employer contributions must be made for all eligible employees, regardless of whether they make salary deferral contributions.

This SIMPLE IRA feature can create a financial challenge for an employer, despite small contribution percentages.

The winner of this feature: The SEP IRA wins in this category because contributions are always discretionary. Whereas for the SIMPLE IRA, contributions can be mandatory.

Employers Should Work With a Team

The SEP and SIMPLE are just two of the retirement plans a small-business owner can adopt. If other retirement plans have not been excluded because of unsuitability, the business owner should work with an advisor to perform a suitability assessment based on all the available options. My Employer Plans for Small Businesses—Comparison Table compares the SEP, SIMPLE, and other retirement plans, focusing on key features and benefits, and is a good start to identifying the ones an employer might like.