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SEP IRA vs. Simple IRA: Everything you need to know

At a glance:

  • SIMPLE retirement accounts (SIMPLE IRAs)

  • Eligibility requirements for SIMPLE IRAs

  • Simplified Employee Pension plans (SEP IRAs)

  • Summary of special types of individual retirement accounts

The individual retirement account (IRA) was created to encourage persons to save money for their future retirement years.

As an incentive to use these accounts, Congress approved income tax savings. Because of their popularity, Congress extended the law to include other accounts under the same tax codes to encourage small businesses to establish employer-sponsored retirement plans. These plans include SIMPLE and SEP IRAs.

Because they fall under the same section of the tax code as individual retirement accounts, they have similar rules to follow regarding contributions, withdrawals, tax benefits, and penalties.

SIMPLE Retirement Accounts (SIMPLE IRAs)

The savings incentive match plan for employees (SIMPLE IRA) is sponsored by employers and is a replacement for salary reduction simplified employee pensions (SARSEPS). The employer may set up IRAs for individual employees. The employer makes annual contributions by:

  • matching up to 3% of pay for employees who contribute, or

  • contributing 2% of pay for all employees whether they contribute or not.

Contribution limits

Employee contributions are limited to the lesser of $13,500 for 2020 or 100% of compensation. Employees age 50 or over may make additional catch-up contributions of $3,000.

Millennials aren't contributing as much to their retirement. (Graphic: David Foster/Cashay)
Millennials aren't contributing as much to their retirement. (Graphic: David Foster/Cashay)

Eligibility Requirements for SIMPLE IRAs

Employees (including self-employed individuals who received earned income) must be allowed to participate in their employer's SIMPLE plan if they:

  • Received at least $5,000 in compensation from the employer during any two years prior to the current year, and

  • Are reasonably expected to receive at least $5,000 in compensation during the calendar year for which contributions are made.

An employer may exclude from eligibility the following:

  • Employees whose retirement benefits are covered by a union contract

  • Employees who are nonresident aliens and received no earned income from sources within the United States

  • Employees who would not have been eligible employees if an acquisition, disposition, or similar transaction had not occurred during the year

Simplified Employee Pension plans (SEP IRAs)

Employers looking for a low-cost, easy-to-administer employer-sponsored retirement plan ought to consider the plans available under the IRS IRA code sections.

What are they?

A simplified employee pension (SEP) plan is an individual retirement account to which employers can contribute. Employees with retirement benefits already established by union agreements may not participate in SEP IRAs. Other employees may participate if they meet the following qualifications:

  • They are at least 21.

  • They have performed services for their company for at least three years during the immediately preceding five years.

  • They have received from their employer at least $600 in annual compensation in 2020, in at least three of the immediately preceding five years.

An employer can establish less restrictive participation requirements for its employees than those listed, but not more restrictive ones.

Contribution limits

The SEP rules permit an employer to contribute (and deduct) each year to each participating employee's SEP-IRA up to 25 percent of the employee's compensation or $57,000 for 2020, whichever is less.

An employer who signs a SEP agreement does not have to make any contribution to the SEP IRAs that are set up. But, if the employer does make contributions, the contributions must be based on a written allocation formula and must not discriminate in favor of highly compensated employees.

Summary of special types of individual retirement accounts

Because of the popularity of the individual retirement account, Congress expanded that section of the tax code to allow for other variations on the individual savings theme. One can now save for one's retirement expenses in more than one way.

While each plan is covered under the same section of the tax code, there are some major distinctions among the different plans.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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