So you read CNN Money, hear about Roth and Traditional IRA’s, and think you’ve got it mastered your retirement options, right?
Wrong. There are more than 2 types you should know about.
Fortunately these kinds of IRA’s mostly only apply to the unique needs small businesses and the self-employed.
You see – Small business owners have to decide whether or not to offer benefits, including a retirement plan to their employees. While many small companies offer health insurance to their workers, finding one that offers a retirement plan is rare.
One of the reasons why small business owners are reluctant to offer a retirement plan to their employees is because they don’t understand the various options available to them. However, research has shown that the more benefits a company offers, the better talent that company will attract.
For this reason, if you are a small business owner, you need to understand a SEP IRA vs SIMPLE IRA. Both plans allow small business owners to expand their benefit packages to their employees by offering a retirement plan. However, there are some significant differences between the two that all business owners should know.
SEP IRA vs SIMPLE IRA – What They Have in Common:
Before you can really get a grasp on the differences between a SEP IRA and a SIMPLE IRA, you need to understand what they have in common. As you may already know, many large companies offer 401K or pension plans to their employees. However, the costs related to setting up and administrating these plans are prohibitive to small companies. After all, you’re trying to make money, not give it all away to set up fees and transaction costs.
In order to make small companies more competitive with the big boys, the IRS established two basic types of retirement plans specifically designed for small business owners and sole proprietors. Both of these plans operate in much the same way as a 401k, but they have fewer administration costs to help small companies provide similar benefits as big companies to their employers. These two plans are the SEP IRA, which stands for Simplified Employee Pension Individual Retirement Account, and the SIMPLE IRA, which stands for Savings Incentive Match Plan for Employees Individual Retirement Account.
The SEP IRA:
When it comes to a SEP IRA vs SIMPLE IRA, the biggest difference is that SEP IRAs do not require employees to contribute to the plan. The employer makes all the contributions on behalf of employees, but those contributions are flexible. This means that an employer does not have to make any contributions at all if profits are down at the end of the year. Conversely, if the company experiences extreme growth and profits were up, the employer can choose to contribute more.
Another main reason why a small business might choose a SEP IRA over a SIMPLE IRA is because the contribution limits are much higher. The employer can contribute as much as 25 percent of an employee’s salary up to $49,000. The only rule regarding contributions that an employer must follow is that they must contribute the same percentage of salary to everyone in the company, including themselves. For example, if the employer decides to contribute 15 percent of his or her salary to the SEP IRA plan, he or she is also required to contribute 15 percent of each eligible employee’s salary as well.
The SIMPLE IRA:
In contrast to a SEP IRA, a SIMPLE IRA operates more like a 401k. Employees determine what percentage of their wages they want to contribute to their IRAs and that amount is pulled out from their paychecks each pay period and deposited directly into their accounts. However, employees do not have to contribute to their accounts in order to benefit from them, even though this isn’t very wise. Employers are required to contribute a flat 2 percent of an employee’s wages to the SIMPLE IRA for those who choose not to participate.
For employees who do like money and choose to participate, the employer has to match up to three percent of contributions made by the employee. So, if an employee wants to contribute three percent of his or her wages every year, the employer would match all three percent. The employee can choose to contribute less, but the match would also be less. The employee can also choose to contribute more, but the employer’s responsibility is capped at three percent. The employer does not have the option not to contribute to a SIMPLE IRA if the business is not doing well.
Finally when comparing a SEP IRA vs SIMPLE IRA, the other major difference is the contribution limits. Remember that SEP IRA contributions can equal 25 percent of an employee’s salary up to $49,000. Well, a SIMPLE IRA is capped at $11,500 per year for employees younger than 50 years old. Those who are over 50 can contribute as much as $14,000 per year, which includes $2,500 in make-up contributions.
Choosing between a SEP IRA and a SIMPLE IRA is actually a choice between two excellent options to enhance your personal finances. It really comes down to how much flexibility you want in the contributions you make and whether or not you want your employees to contribute to their retirement. You can’t go wrong either way because regardless of which one you choose, you are helping your employees save for their future.
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