Choosing between a SIMPLE and SEP IRA depends on factors such as the number of employees and net income. SIMPLE IRAs are for businesses with fewer than 100 employees, while SEP IRAs are for high-income entrepreneurs without employees. The biggest difference is the amount that can be contributed tax-deferred, which depends on income. Both plans have penalties for early withdrawal, but the penalty is higher for SIMPLE IRAs.
A business owner trying to choose between a SIMPLE and a SEP IRA needs to know a little about these two plans and how they differ. Making the best choice between these two types of IRAs, or individual retirement accounts, can depend on several variables, such as whether the company has employees and the amount of net income it generates each year. Other considerations may include any contribution limits, tax ramifications, or early withdrawal penalties associated with individual IRAs.
SIMPLE IRAs, or Employee Savings Incentive Plan 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 generally cover businesses with fewer than 100 employees when no other retirement plan exists. The employer can choose to match employee contributions to the account up to 3 percent of salary or contribute 2 percent of salary to each employee’s account, regardless of the employee’s contribution. Sole proprietors could contribute up to $11,500 of net income, up to $14,000 if age 50 or older, for 2010.
SEP, or Simplified Employee Pension, IRAs are most commonly used by high-income entrepreneurs who do not have 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 receipts less expenses, the deduction for half of the self-employment tax paid, as well as the amount of the SEP IRA contribution for that year. The latter amount can be quantified because the account can be established one year after the contribution year, as long as it is in effect before April 15 or, if an extension is filed, October 15.
There are several differences between a SIMPLE and a SEP IRA. While both will incur a penalty if a withdrawal occurs from the account within the first two years of its existence, the penalty is higher (25 percent) for a SIMPLE IRA than for a SEP IRA, which incurs a penalty of 10 percent withdrawal. Also, while SIMPLE IRA plans can also be funded through October 15 of the next tax year, the law says the plan must have been established before October 1 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 accounts tax-deferred, which is entirely dependent on income. For the entrepreneur with a net income of less than $46,000, the annual contribution of $11,500 or $14,000 SIMPLE IRA can be doubled, because the owner can contribute as an individual and, as a 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 the net income is quite high: a net income of $196,000 will provide the maximum contribution of $49,000 under SEP rules, whereas, with a SIMPLE IRA plan, the contribution level will not change. Participants in either plan may also contribute to traditional or Roth IRAs.
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