IRA stands for Individual Retirement Account. If you have not read about the most common IRAs, Traditional and Roth, you should start with that post. IRAs are designed for individuals to save for retirement with unique tax advantages. As a refresher, as of 2020, there are four types of IRAs:
Traditional IRAs
Roth IRAs
SEP IRAs
SIMPLE IRAs
This post will focus on SEP and SIMPLE IRAs because they are both designed for small businesses or the self-employed. Like all IRAs, they are tax-advantaged accounts designed for retirement savings. However, there are some unique rules that govern these particular retirement savings vehicles that all small business owners should be aware of.
SEP IRA
SEP IRA, often just called a SEP, is an acronym for Simplified Employee Pension. Because these are truly simple, this section will be brief! SEPs are only for the self-employed or small business owners and have the same tax and withdrawal rules as Traditional IRAs. All contributions to a SEP are tax deductible (or pre-tax), investments in SEPs grow tax deferred, and every dollar withdrawn in retirement is fully taxable as income. Just like all other IRAs, distributions are allowed without additional penalty at age 59 ½ and just like Traditional IRAs, distributions known as RMDs must begin at age 72.
This, however, is where the similarities end.
SEPs must be established by a business and each employee gets their own SEP account. What is unique about SEPs is that contributions to SEPs can only be made by the employer/business owner, not by any employees. The business owner can then deduct the contributions made to the employees’ SEPs from the taxable income of the business, which reduces the business’ tax liability for that year. Contribution limits in 2020 for each individual employee in the business are the lesser of 25% of compensation or $57,000. So, these are vehicles that you can sock away much larger chunks of money than the individual IRA options.
*Pro Tip* SEPs are great options for sole proprietors or small businesses where the owner’s salary is dramatically higher than the other employees because the contribution percentage (up to the limits) must be equal across all employees. So, if an employer has several highly compensated employees, this option can get very expensive!
SEP IRA In A Nutshell – SEPs provide the highest contribution limits of all IRAs. Contributions can only be made by the employer and are tax deductible, growth is tax deferred, and all distributions in retirement are fully taxable as income. A SEP would be a great option for a sole proprietor looking to dramatically reduce taxable income and maximize annual retirement savings.
SIMPLE IRA
SIMPLE IRAs are another vehicle designed for small business owners and the self-employed. SIMPLE stands for Savings Incentive Match Plan for Employees. SIMPLEs are generally inexpensive to establish and maintain. Again, it has the same taxation and withdrawal rules as Traditional and SEP IRAs. But, unlike SEPs, SIMPLEs allow for BOTH employee contributions as well as employer contributions, just with lower limits than a SEP.
SIMPLEs allow for a $13,500 employee contribution in 2020 with a $3,000 catch up contribution for those 50 and older. Employers are able to structure their contributions in two ways:
Employer Match: A dollar for dollar match up to 3% of employee compensation (similar to how 401(k)s are often structured).
Flat Contribution: Employer can contribute a flat 2% of employee compensation for every employee no matter if the employee contributes or not.
*Pro Tip* If you participate in a SIMPLE and want to transfer it to a different type of IRA account, you MUST WAIT 2 YEARS before you transfer otherwise you will be subject 25% penalty! Ouch!
SIMPLE IRA In A Nutshell – SIMPLEs function as miniature 401(k)s for small businesses. Contributions are tax deductible and can be made by both employee and employer. Investment growth is tax deferred and all withdrawals in retirement are fully taxable as income. SIMPLEs are a good fit for small businesses looking to offer a tax deferred retirement plan for employees but don’t want to go to the expense of establishing a 401(k).
SEP vs. SIMPLE Comparison
Summary
IRAs are wonderful vehicles for retirement savings and the SEPs and SIMPLEs offer flexibility for small businesses and the self-employed. The higher contribution limits can help with increased tax deductions and can jump start the tax deferred growth for retirement! Make sure you understand the costs and limitations of each of these accounts and, as always, pay particular attention the investments chosen within your IRAs. Tax deferral is an incredibly powerful tool, but it can be wasted with poor investment selections.
Disclosures:
This information has been provided for general educational purposes only; it has been obtained for sources deemed to be reliable but we cannot guarantee that it is accurate or complete. The information provided is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. All investing involves some degree of risk, investors may incur a profit or loss regardless of the strategy or strategies employed. Every investor’s situation is unique, you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making an investment decision, please consult with a financial professional about your individual situation. Raymond James Financial Services, Inc. and its advisors do not provide advice on tax, legal or mortgage issues. These matters should be discussed with the appropriate professional.