401(k) vs. SIMPLE IRA vs. SEP IRA

401(k) vs. SIMPLE IRA vs. SEP IRA

May 07, 2024

In today’s labor environment it has become increasingly difficult to retain employees without offering some form of benefits. Most businesses that employ full time associates offer benefits such as health, dental, and vision. In addition, many employers offer a company sponsored retirement plan. The form that such a plan takes depends largely on the number of employees and the overall size of the company. In general, most employer sponsored retirement plans will fall into one of three different categories: 401(k), SIMPLE IRA, and SEP IRA plans.

 

SIMPLE IRA

                A business with fewer than 100 employees may elect to start a SIMPLE IRA plan. In this type of plan, an employer is required to make a contribution equal to 3% of each eligible employee’s pay. There are some exceptions to this rule but this is certainly the norm. In a SIMPLE IRA, each employee has their own account which they themselves can contribute to in addition to their employer contributions. Contributions are made on a pre-tax basis which means that all withdrawals are taxed in retirement. Additionally, like any other IRA, withdrawals prior to age 59 ½ are penalized by the IRS. Employee contributions to the plan are limited to an annual amount ($16,000 in 2024) however, the IRS provides those 50 and older with the option to make catch-up contributions as well ($3,500 in 2024). Since a SIMPLE IRA is an individual account, you are not allowed to take loans on the account although there are some provisions available for taking penalty-free withdrawals.

                For employer’s, a SIMPLE IRA can be an extremely cost-effective option. Aside from their contributions to employee accounts, the fees for starting such a plan are extremely minimal. In addition, the IRS is offering generous tax incentives to businesses who elect to start a new retirement plan for their employees. It is important to note that SIMPLE IRA are only available to employers with less than 100 employees. Once an employer reaches 100 employees, they enter a 2-year grace period in which time they will need to transition to another plan type such as a 401(k).

 

SEP IRA

                Occasionally, business owners do not wish to start a full-blown 401(k); however, they also want to avoid the obligation of making employer contributions. A SEP IRA could be a great way to accomplish this goal. A SEP IRA can be set up at any time in the calendar year and there are no restrictions when it comes to the size of the employer or number of employees. Like a SIMPLE IRA, each employee has their own, separate account into which contributions are made and invested. SEP IRA plans are much the same as SIMPLE IRA plans when it comes to the rules for withdrawals but differ in the areas of contributions and contribution limits. SEP IRA plans are funded 100% by employer contributions which means that employees are not able to defer contributions from their paychecks unlike in a SIMPLE IRA. This is somewhat akin to a 401(k)-profit sharing plan (which we will discuss next) in which the company can make contributions to the employee’s accounts based on profits.

                In addition, contribution limits for SEP IRAs can be significantly higher than SIMPLE IRA’s depending on the income levels of the participants. Employers are able to contribute up to 25% of each eligible employee’s income in any given year (up to $69,000 in 2024). The only stipulation is that if an employer decides to make a contribution, then each employee who is eligible for the plan must receive a contribution equal to the same percentage of their income. For example, if an employer decided to make 8% contributions on behalf of its President and CFO, it would also need to make 8% contributions for each of the other eligible employees. Again, employers are not required to make contributions of a certain dollar amount or frequency but if they do decide to make a contribution, then every eligible employee is entitled to the same percentage.

                Like SIMPLE IRAs, this plan type has little to no start up costs other than potential employer contributions. SEP IRAs hold particular benefit for sole proprietors who do not have any full-time employees as they allow them to defer large sums of money from their taxes. Additionally, a SEP IRA can be open and funded for the prior tax year right up until tax returns need to be filed.

 

401(k) Plans

                Of the three options we are discussing today, 401(k) plans typically have the highest set up costs and are overall the most labor intensive to get started. In some ways, however, they are also the most flexible plan type in that they can be customized to fit the needs of the sponsoring employer and their employees. Like a SEP IRA, employer’s have the ability to set up a 401(k) without matching contributions. Typically, such a plan would also include a “profit sharing provision” akin to employer contributions in a SEP IRA. However, 401(k) plans always allow for employee contributions like a SIMPLE IRA albeit without the mandatory 3% employer contribution. Therefore, employers who sponsor a 401(k) have the ability to choose their matching contribution percentage (if at all) as well as any additional profit-sharing contributions.

                Modern plans also often include a Roth contribution option unlike their SIMPLE IRA and SEP IRA counterparts (although recent legislation has cleared the way for Roth contributions in both of those plan types as well). That same legislation has also made it possible for employer contributions to made on a Roth basis in addition to Roth employee contributions. Unlike the other plan types we have discussed, many 401(k) plans also include a loan provision making it possible for plan participants to take loans against their account balance (limited to the lesser of 50% of their balance or $50,000). Not every employer elects to offer this option in their plan as it can be burdensome to administer.

                Much like a SEP IRA, an employer is not required to have a certain number of employees in order to start a 401(k). In fact, it is possible to start a 401(k) with only one participant (the business owner) in what is commonly referred to as a Solo 401(k). The employee contribution limits in a 401(k) are similar but a bit higher than SIMPLE IRAs ($23,000 in 2024) and also include a catch-up contribution ($7,500 for those over 50 in 2024). There are additional rules and regulations relating to 401(k) plans that are not found in the other plan types. Specifically, there are additional tax filings that need to be prepared, plan audits if there are more than 100 eligible employees, and rules that prohibit the plan from favoring highly compensated executives.

                If you are an employee of a company that sponsors one of these plan types then I hope this blog post has clarified a few things for you. Likewise, if you are a sponsoring employer or are an employer considering starting a new retirement plan, then I hope this gave you the basics the think about. Either way, should you have any questions about employer sponsored retirement plans please reach out and I would be happy to help!

 

 

The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results.

 

This information is intended to be educational and is not tailored to the investment needs of any specific investor.