SEP and SIMPLE Retirement Plans for Small Employers

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A hallmark of the twenty-first century is the fact that most retirees, particularly in the private sector, will retire without traditional employer-funded pensions. Instead, current retirees are primarily funding retirement with personal savings and benefits from employer-sponsored 401(k) or similar defined contribution retirement savings plans. Congress has long had the objective of increasing both the number of employees participating in retirement savings plans and the number of employers sponsoring them. Two of the solutions have been the “Simplified Employee Pension” IRA or SEP plan, enacted in 1978, and the “Savings Incentive Match Plan for Employees” or SIMPLE, enacted in 1996.

Retirement Plan 101: Pensions vs. 401(k) and Profit-Sharing Plans

Pensions, or defined benefit plans, require the employer to pay the retired employee (or the employee and the employee’s spouse) a fixed annuity for life. The employer has contractual obligations to the participating employees and regulatory obligations to fund its pension responsibilities, and the employee does not have any control over the amount saved or how it is invested. In contrast, 401(k) and similar plans and IRAs allow the employee to decide whether to contribute, how much to contribute (up to a cap) and how to invest the funds, potentially from a limited pre-selected group of options. Employers may make additional contributions to the savings plan, either as profit sharing or by matching employee contributions, but are not required to do so.

From the employee standpoint, a pension can provide a degree of certainty and protection from outliving retirement savings. However, employers can go bankrupt, preventing them from making pension plan contributions, and pension plans themselves may, through investment decisions or other misfortune, be unable to meet their obligations. While there are government pension guarantors that provide some protection after this type of misfortune, the retiree may only receive limited benefits rather than the expected pension amount. In addition, if a retiree dies prematurely, the pension annuity can end and leave nothing to provide for the retiree’s family.

Another disadvantage of a pension plan is that there are no pre-retirement distributions permitted, while a 401(k) plan may offer the employee the right to borrow from the plan or to take hardship withdrawals prior to retirement. Finally, a big disadvantage of traditional pensions from the employee’s perspective is that most pension benefits reward long tenure, meaning that changing employers comes at a cost to pension benefits. 401(k)s give employees the ability to choose investments in accordance with their own risk tolerances and investment objectives, and also make the entire amount (after any vesting period for employer contributions) completely portable so there is no loss of savings momentum when changing jobs.

Challenges for Small Employers and the Self-Employed

One of the issues for small employers and the self-employed is the complexity involved in creating and maintaining retirement plans for small numbers of employees. In addition to the cost of establishing the plan, there are ongoing administrative burdens and compliance requirements. The per employee cost of this can be significant for a business with only a handful of employees.

This is where SEP and SIMPLE plans provide an easier and more cost-effective option. Each one is a tax code created plan that relies on each employee’s IRA to manage the investment, distribution and tax reporting for contributions made through the plan. An employer can adopt the plan using a form plan agreement published by the IRS, by prototype plan agreements offered by financial services providers or by customized plans drafted by the employer. In each case, each employee has their own IRA to receive plan distributions, and any investments open to the IRA are available options for the SEP or SIMPLE account. There are fewer compliance requirements for the employer, and the employee is always 100% vested in their account. Note that these options are for employers without other retirement plans.

SEP Plan Basics

SEP plans can only receive contributions from the employer – there is no ability for the employee to make elective contributions, and catch-up contributions are not permitted. The contribution percentage must be the same for all eligible employees. The contribution limits for 2024 are the lesser of 25% of the employee’s compensation or $69,000. Note that this is significantly more than an employee can save for themself in a traditional or Roth IRA. The contribution amount does not need to be the same each year, which is like a profit-sharing plan, and it is therefore useful in companies where cash flow fluctuates. These are particularly popular with self-employed individuals due to the flexibility and the ability to save more than an IRA permits.

An employer may (but is not required to) limit SEP participation to those employees who are over age 21, who have worked for the employer in three out of the preceding five years and who have received at least $750 in compensation for the year. The only employees that an employer is permitted (but not required) to exclude are union members subject to a collective bargaining agreement and non-resident aliens who do not receive U.S. wages from the employer.

To create a SEP plan, the employer is required to adopt the plan using an IRS Form 5305-SEP (no later than the due date, including extensions for the employer’s return for the first year of contribution), provide required information to the employees and establish a SEP IRA for each participating employee. Contributions are due by the filing date for the employer’s tax return – even with an extension – and contributions are deductible by the employer (self-employed persons get the deduction themselves) and excludible from the employee’s income. The rules for withdrawing assets from the plan are those that govern IRAs. While the SEP IRA had to be a traditional (non-Roth) IRA prior to 2023, it is now possible to create a Roth SEP plan.

SIMPLE Plan Basics

SIMPLE plans, unlike SEP plans, are designed to allow employees to make elective deferrals of their compensation like a 401(k) plan. Even though SIMPLE plans can be set up as SIMPLE 401(k)s, they are very uncommon due to the extra administrative work. The employer is required to contribute to the plan every year and can choose either a match of the employee’s elective contributions up to a maximum of 3% of the employee’s compensation (which can be reduced to not below 1% under limited circumstances) or a contribution equal to 2% of compensation for each employee regardless of whether the employee elects to contribute anything. Beginning in 2024, an employer can make an additional non-elective contribution to all eligible employees who have at least $5,000 of compensation for the year. This additional contribution can be up to 10% of compensation but not more than $5,000, and contributions must be made in a uniform manner to all employees.

Each employee may elect to contribute up to $16,000 for 2024 (and may make permitted catch-up contributions of $3,500 if over age 50) adjusted for any other plans the employee may contribute to. Beginning in 2024, employers with 25 or fewer employees may elect to allow higher deferral amounts, and employers with more than 25 employees can make such an election if the employer also increases its contributions. Starting in the 2025, SIMPLE IRA participants aged 60 through 63 can contribute the greater of $10,000 or 150% of the 2024 catch-up contribution limit – separate from the maximum $3,500 catch-up contribution for which workers between the age of 50 and 59 are eligible. Increased catch-up limits will revert to the generally applicable age 50-59 limits beginning with the tax year in which the participant reaches age 64. The deferral election is made annually within a 60-day window, typically November 2 through December 31, except for the first year of a plan with a start date other than January 1.

Like a SEP plan, a SIMPLE plan is attractive as a low cost, low complexity option for an employer. It is established by executing IRS form 5304-SIMPLE or 5305-SIMPLE. 5304 is for employers who allow the participants to select their own IRA providers, and 5305 is for employers who will use a single financial institution for all participants. As with a SEP, there are alternative prototype plans offered by financial services providers, and an employer could also choose a custom plan instead. For 2023 and subsequent years, Roth contributions are permitted as well.

The employer must give required annual notices to the employees and ensure that the employees have SIMPLE IRA accounts in place. No tax filings are required by the employer. No employee loans are permitted, and the rules governing IRAs apply with respect to taxation and distribution rules. Employers may exclude employees who did not receive $5,000 in compensation in one of the two preceding calendar years or who do not anticipate receiving $5,000 in the current plan year, those covered by collective bargaining agreements and non-resident aliens who do not receive U.S. compensation from the employer. They cannot exclude employees on other grounds. The plan sponsoring the SIMPLE must have no more 100 employees and may exceed that limit only for a two-year grace period. The employer must deposit salary reduction amounts (employee elected contributions) within 30 days after the month in which the salary was earned. The employer’s contributions must be made no later than the due date for the employer’s tax return. All employer contributions and associated earnings are 100% vested.

Roth SEP & SIMPLE IRA

Since January 1, 2023, SIMPLE IRA participants have had the ability to make salary deferral contributions to a Roth SIMPLE IRA. Like a Roth 401(k) deferral, a SIMPLE participant must make an election to have the contribution treated as a Roth and, similarly, contributions are considered taxable income. Employer contributions (match or non-elective) can also be made on a Roth basis for SEP or SIMPLE IRAs.

Any SEP or SIMPLE contribution made to a Roth IRA on the participant’s behalf is not excludable from the participant’s gross income. An employer match or non-elective contribution made to a Roth SEP or SIMPLE IRA is included as taxable income in the tax year it is contributed. For elective deferrals, income is included in the year the participant would have otherwise received the amount as wages or salary.

However, it will take time for IRA custodians and employers to update their paperwork, processes and systems to allow for such contributions. The IRS has extended the deadline to December 31, 2026, to incorporate changes in law or regulations into IRA agreements or IRA-based employer plans, so not all plans may currently be offering a Roth option.

Considerations for small employers and the self-employed

Small employers and even the self-employed are permitted to create the same range of retirement plans that large employers do. And there may be good reasons to consider them, such as delaying the vesting of matching funds for new employees or permitting loans. However, the administrative simplicity of SEP and SIMPLE plans can be more appealing in many circumstances. Providing retirement benefits can be an inducement to staff, a tax break for the self-employed and smart financial planning given the opportunity for tax-deferred growth in employee accounts.

SEP and SIMPLE IRA plans both offer opportunities for retirement savings. The choice of which one to use depends on the type of contributions the employer wants to make, whether to allow employee salary deferral and what the record-keeping and transfer of elected salary deferrals will entail.