SEP, SIMPLE, and Individual(k) Plans: Navigating the Retirement Plan Options for Small- to Mid-sized Businesses
By Agatha Schmidt, CISP, SDIP, CHSP
For small- to mid-sized businesses that are considering offering a retirement plan for their employees, typical employer-sponsored plans like pension plans or 401(k) plans are sometimes considered cost-prohibitive or too complicated to administer. There are three types of plans that are easier to administer and less expensive to maintain: Simplified employee pension (SEP) plans, Savings incentive match plan for employees of small employers (SIMPLE) IRA plans, and Individual(k) plans.
SEP Plans
SEP plans, a popular choice among self-employed individuals and small businesses, may be maintained by all types of businesses, including tax-exempt organizations and state and local governments. Only employer contributions may be made to a SEP plan.
SIMPLE IRA Plans
A SIMPLE IRA plan allows both employer and employee plan contributions, but is more restrictive in terms of employer eligibility; only employers who had no more than 100 employees receiving at least $5,000 in compensation in the preceding calendar year are eligible to maintain such a plan. Additionally, eligible employers may not offer any other type of employer-sponsored retirement plan.
Individual(k) Plans
An Individual(k) plan is an owner-only 401(k) profit sharing plan that, like SIMPLE IRA plans, allows both employer and employee plan contributions. Unlike conventional 401(k) plans, Individual(k) plans are not subject to complicated testing, or special reporting requirements until plan assets reach $250,000. Individual(k) plans offer a higher contribution limit and allow participants to make Roth deferrals and to take plan loans—features that SEP and SIMPLE plans do not have.
Eligibility and Establishment
SEP Plans
Employers who maintain a SEP plan can set employee eligibility requirements, but the requirements must apply to all employees—including the employer. Employers may exclude certain nonresident aliens and union employees. They may also exclude employees who have not
attained age 21;
worked during three out of the immediately preceding five years (any amount of time, however short, counts as a year of service); or
earned at least $650 in compensation during the year.
NOTE: These are the most restrictive eligibility requirements. An employer can be less restrictive with these requirements, but not more restrictive.
An employer has until its business’s federal income tax return due date, including extensions, to establish a SEP plan. A signed, written agreement containing information about the plan must be provided to all employees.
SIMPLE IRA Plans
An employee generally qualifies to participate in her employer’s SIMPLE IRA plan if she has earned at least $5,000 in any two preceding years and is expected to earn at least $5,000 in the current year. Like SEP plans, employers may choose to be less restrictive in terms of their eligibility criteria, and can exclude certain nonresident aliens and union employees from the SIMPLE IRA plan.
A SIMPLE IRA plan must be established and operational generally no later than October 1. Employers must complete the plan documents and retain a copy with their business records. Employees must receive a summary description and participation notice timely.
Individual(k) Plans
Individual(k) plans are most suitable for sole proprietors, family businesses with a spouse-only employee, partnerships—including partners’ spouses—one-shareholder corporations, limited liability companies, and businesses with excludable common-law employees. If eligible employees are hired, the plan becomes subject to nondiscrimination testing, and recordkeeping duties and administration expenses may increase.
To establish an Individual(k) plan, the employer must complete and sign the appropriate plan documents by the business’s tax return due date, plus extensions, for the year for which the employer intends to deduct the contributions.
Employers have until the business’s tax return due date, plus extensions, to deposit a profit sharing contribution and their own deferral contribution. But Treasury regulations require employees (including employers) to make salary deferral elections before they would otherwise receive the compensation that they defer into the Individual(k) plan. Because compensation for self-employed individuals is deemed currently available on the last day of the business’s taxable year, a self-employed individual generally has until the last day of the business’s taxable year to make a deferral election. Therefore, an employer should make a deferral election no later than the last day of the company’s taxable year.
Contributions and Distributions
SEP Plans
Contributions are made at the employer’s discretion to all eligible employees, and the same allocation formula must be applied to all eligible employees—including the employer. To receive employer contributions, eligible employees must establish a Traditional IRA (or have one established for them by their employer).
The maximum contribution amount per eligible employee is the lesser of 25 percent of the employee’s compensation (up to defined compensation cap), or $58,000 for 2021 and $61,000 for 2022. Contributions must be made by the employer’s business federal tax return due date, including extensions.
Similar to Traditional IRA contributions and earnings, SEP plan contributions and earnings remain tax-deferred until distributed and generally follow the same rules as Traditional IRAs.
SIMPLE IRA Plans
Employees must open SIMPLE IRAs to receive contributions. They may elect to make salary deferrals on a pretax basis up to $13,500 for 2021 and $14,000 for 2022, plus an additional $3,000 if they are age 50 or older. Employer contributions are mandatory for SIMPLE IRA plans. The employer must make a three percent matching contribution for employees who make salary deferrals, or a two percent contribution for all eligible employees, regardless of whether they defer. The employer may also choose to make a lower matching contribution, but only for two years of any five-year period.
Like SEP plan contributions, SIMPLE plan contributions and any earnings are tax deferred. Both employer contributions and employee deferrals are considered fully vested and available to the employee at any time. But SIMPLE IRA distributions are subject to a 25 percent early distribution penalty tax if distributed within a two-year period beginning on the date that the first contribution under the employer’s SIMPLE IRA plan is made to the employee’s SIMPLE IRA. The early distribution penalty tax does not apply if the employee is age 59½ or older or qualifies for a penalty tax exception. If an employee under age 59½ satisfies the two-year requirement, a 10 percent early distribution penalty tax would apply instead of 25 percent.
Individual(k) Plans
Profit-sharing contributions are made at the employer’s discretion, and no more than 25 percent of compensation can be made as a deductible profit-sharing contribution. The employer may also defer the lesser of 100 percent of his compensation or $19,500 for 2021 and $20,500 for 2022 on a pretax basis, or on a designated Roth basis if the plan allows. Individuals age 50 or older may defer up to an additional $6,500. Total contributions (profit-sharing contributions and salary deferrals) for each individual cannot exceed the lesser of 100 percent of compensation or $58,000 for 2021 and $61,000 for 2022; individuals age 50 or older may increase this limit to include up to $6,500 as a catch-up contribution.
For a plan distribution to be allowed, a “triggering event” (as defined in the plan document) must occur. Salary deferrals are generally not available for distribution from an operating plan before age 59½ . A distribution of pretax assets is generally taxable, whereas Roth qualified distributions are generally not subject to taxation.
Business owners considering these retirement plan options, or any others, should consult with a competent tax or financial advisor about which plan is right for their business.
