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How do I Choose Between a SIMPLE and a SEP IRA?

By Amanda Lacasse
Updated May 16, 2024
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A business owner trying to make a choice between a SIMPLE and a SEP IRA needs to know a bit about these two plans and how they differ. Making the best choice between these two types of IRAs, or individual retirement accounts, may depend on several variants, such as whether the business has employees and how much net income the business makes per year. Other considerations may include any contribution limits, tax ramifications or early withdrawal penalties attached to particular IRAs.

SIMPLE IRAs, or Savings Incentive Match Plan for Employees IRAs, were created so small business owners could set up retirement accounts for their employees and themselves without complicated rules and reams of paperwork. These plans usually cover businesses with fewer than 100 employees when no other retirement plan exists. The employer can elect to either match employee contributions to the account up to 3 percent of salary or contribute 2 percent of salary to each employee account, regardless of employee contribution. Individual owners could contribute up to $11,500 of net income — up to $14,000 if they are over age 50 — for 2010.

SEP, or Simplified Employee Pension, IRAs are more commonly used by high-earning entrepreneurs who have no employees. These plans allow the owner to contribute 25 percent of net earnings, up to $49,000 in 2010, into the account. The term "net earnings" means gross income minus expenses, the deduction for half of paid self-employment tax, as well as the amount of the SEP IRA contribution for that year. The latter amount can be quantified because the account may be set up the year after the contribution year, as long as it is in place by 15 April or, if an extension is filed, 15 October.

There are several differences between a SIMPLE and a SEP IRA. While both will incur a penalty if a withdrawal from the account occurs within the first two years of its existence, the penalty is higher — 25 percent — for a SIMPLE IRA than it is for a SEP IRA, which incurs a 10 percent withdrawal penalty. Also, even though SIMPLE IRA plans may be funded as late as 15 October of the next tax year as well, the law says the plan must have been established by 1 October of the tax year in question.

The biggest difference between a SIMPLE and a SEP IRA is the amount the business owner can contribute to these tax-deferred accounts, which is entirely dependent on income. For the entrepreneur with a net income of less than $46,000, the $11,500 or $14,000 yearly SIMPLE IRA contribution may be doubled, because the owner can contribute as an individual and, as the business owner, match that amount. A SEP IRA would allow a contribution of only $11,500 at the same income level. The most important difference between a SIMPLE and a SEP IRA becomes apparent when net income is quite high: a net income of $196,000 will provide the $49,000 maximum contribution under SEP rules while, with a SIMPLE IRA plan, the contribution level would not change. Participants in either plan may contribute to traditional or Roth IRAs, as well.

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