What is the Difference Between a SEP IRA & a Simple IRA

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Simplified Employee Pension and Savings Incentive Match Plan for Employees IRA retirement plans share some similarities, but also critical differences. Both plans are designed for small businesses, both are cost-effective and easy to administer, and neither has an annual financial reporting requirement. However, this is where their similarities end. Understanding their differences is vital, because you can’t have both plans in place at the same time.

Funding and Focus

Differences in funding requirements make a SEP IRA more suitable for a small business with few to no employees. An employer can decide each year whether or not to contribute to a SEP IRA plan. However, funding is an all-or-nothing deal. If you invest in one account, you must make the same investment in all accounts. For example, if you contribute $5,000 to your SEP IRA, you must do the same for each employee.

With a SIMPLE IRA, which unlike a SEP IRA is only an option for businesses with up to 100 employees, there is an annual contribution requirement. However, the amounts can be either a matching contribution of one percent to three percent of an employee’s gross wages for those who also contribute, or a two percent nonelective contribution to accounts. Either way, a SIMPLE IRA is a more cost-effective option for a business with employees.

Tax Considerations

With regard to tax breaks, a SEP IRA favors the employer while a SIMPLE IRA favors employees. SEP IRAs do not allow for employee contributions, so you as an employer do all of the funding. However, 100 percent of the funds you contribute to your own account and to your employees' accounts are tax deductible. In contrast, a SIMPLE IRA does allow for employee contributions via pre-tax salary deductions. Although the amount you invest is still tax deductible, employees contribute a greater portion and receive a larger tax break.

Vesting and Withdrawals

With both a SEP and SIMPLE IRA, accounts are fully vested as soon as a contribution is made. This means the money belongs to the employee. Both plans also impose early withdrawal penalties. A SEP IRA is subject to a 10 percent penalty in addition to income taxes. Early withdrawal penalties for a SIMPLE IRA differ only in the first two years of opening the account. The penalty in the first two years for taking a withdrawal before reaching age 59 ½ is 25 percent in addition to income taxes.

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