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George F. Bearup, J.D. Senior Legal Trust Advisor

8-Jun-20

SEPs and SIMPLEs – IRA-Based Employer Savings Plans

Take-Away: A Simplified Employee Pension IRA (SEP) and a Savings Incentive Match Plan for Employees IRA (SIMPLE) have similar features, but they also have different rules that are often confused. While they are technically qualified plans, they are subject to IRA tax rules, not the rules that  generally apply to other qualified plans like 401(k) accounts. Different rules that are applied to SEP IRAs and SIMPLE IRAs can lead to mistakes.

Background:  A small business may elect to sponsor an IRA-based savings plan for its employees. The current choice is either a SEP IRA or a SIMPLE IRA.

  • SEP IRA: A SEP IRA plan allows the employer to make contributions to a traditional IRA for eligible employees. SEP IRA plans do not permit employee contributions. While an employer of any size can adopt a SEP IRA, mostly small employers establish a SEP IRA plan due to their administrative simplicity.
  • SIMPLE IRA: A SIMPLE IRA plan is limited to business sponsors with 100 or fewer employees. SIMPLE IRA contributions are made to a SIMPLE IRA for each employee. A SIMPLE IRA plan allows the employees to make elective deferrals. Each year the employer must either match the employee’s elective deferral, dollar-for-dollar up to 3% of pay, or make a contribution equal to 2% of pay to all eligible employees, including those employees who choose not to defer any of their salary.
  • SARSEP IRA:  Prior to 1997 an employer could have established a SEP IRA that included elective deferrals, known as a Salary Reduction Simplified Employee Pension, or SARSEP. The SIMPLE IRA was designed to replace the SARSEP. SARSEP plans cannot be established after 1996. However, existing SARSEPs continue to operate, even for new employees.

Common Rules: Several rules apply to both SEP IRAs  and SIMPLE IRAs. They can be quickly summarized as follows:

  • No Roth nor After-Tax Contributions: SIMPLE IRAs and SEP IRAs can only accept pre-tax contributions.
  • Traditional IRAs: Owning a traditional IRA has no impact on the ability to make contributions made to a SEP IRA or SIMPLE IRA
  • No Loans: Just like with traditional IRAs,  no loans  can be taken from the SEP IRA or SIMPLE IRA. Any loan is a prohibited transaction causing the entire IRA balanced to be treated as distributed.
  • Distributions At Any Time: Comparable to a traditional IRA, distributions can be taken at any time from a SEP IRA or a SIMPLE IRA. Contrast this ‘easy access’ to a qualified plan account where often there must be a termination of employment before a distribution can be taken by the participant, or the participant must show a ‘hardship’ to access funds in his/her account.
  • RMDs: Distributions from the SEP or SIMPLE IRA must commence when the account owner attains age 72.
  • No ‘Still Working’ Exception: Even though a SEP IRA or SIMPLE IRAs are employer sponsored, if the employee continues to work after age 71, he/she cannot avoid taking RMDs because they are ‘still working.’ This is different for a qualified plan where the ‘still working’ exception can apply to delay having to take an RMD once age 72 is attained.
  • Account Aggregation: SEP IRAs and SIMPLE IRAs can be aggregated with traditional IRAs owned by the same individual with regard to calculating the RMD for the year. Once the account balances are aggregated and the RMD for the year is determined, the RMD can be taken from any one or more IRA account chosen by the IRA owner.
  • Bankruptcy Protection: SEP IRAs and SIMPLE IRAs are completely protected in the owner’s bankruptcy. Unlike a traditional IRA ($1.2+ million), there is no dollar limit that is protected in bankruptcy with a SEP IRA or SIMPLE IRA, which treats them more like a qualified plan.
  • Creditor Protection: In non-bankruptcy situations, a SEP IRA and SIMPLE IRA are protected under Michigan’s exempt property statute, as they are ‘IRAs.’
  • Qualified Charitable Distributions: SEP IRAs and SIMPLE IRAs can be the source of qualified charitable distributions, but only if the SEP/SIMPLE IRA is inactive (i.e. no deductible contributions are made the year of the QCD.

Different Rules: While SEP IRAs and SIMPLE IRAs are both employer sponsored IRAs with many similarities, as noted above, there are still some different rules applied to each, which makes always treating them as identical IRAs a mistake.

  • Elective Deferral Limits: As noted earlier, elective deferrals are not allowed for SEP IRA accounts. For SIMPLE IRA plans, the 2020 elective deferral amount is $13,500. The ‘catch-up’ contribution limit for employees age 50 and older, is $3,000 a year. [Comparison: 401k elective deferral contribution limits for 2020 are $19,500 with a ‘catch-up’ contribution limit of $6,500.]
  • Maximum Contribution Limit: Employer contributions to a SEP IRA may not exceed the lesser of $57,000 (in 2020) or 25% of compensation. Total SIMPLE IRA contributions cannot exceed the sum of the elective deferral limit ($13,500, plus ‘catch-up’) and the amount of employer contributions. [Comparison: The combined employer and employee contribution limit for a 401(k) account in 2020 is $57,000 plus ‘catch-up’ contributions.]
  • Early Distribution Penalty: Unless one of the exceptions apply to IRA distributions, e.g. first home purchase; adoption or birth expenses; tuition payments,  both pre-age 59 ½  SEP IRA and SIMPLE IRA distributions are subject to the 10% excise tax for an early distribution. However, the pre-age 59 ½ distribution from a SIMPLE IRA is subject to a 25% excise tax, not a 10% excise tax, during an initial two-year holding period that commences on the date of the employee’s first contribution to the SIMPLE IRA.
  • Rollovers: During the initial two-year holding period, SIMPLE IRA funds can only be rolled over to another SIMPLE IRA. Along the same lines, a SIMPLE IRA can only accept a rollover from another SIMPLE IRA during the initial two-year holding period . After the two-year holding period, SIMPLE IRA funds can be rolled over to a traditional IRA or to an employer qualified plan. In addition, SIMPLE IRA funds, after the initial  two-year holding period can be converted to a Roth IRA. Traditional IRA funds and qualified plan funds can be rolled into a SIMPLE IRA after the initial  two-year holding period. SEP IRAs do not have any holding period restrictions.

Conclusion: SEP IRAs and SIMPLE IRAs are just two of many employer sponsored savings plans. Other employer sponsored savings plans include 401(k) qualified plans (private sector employers), ‘solo’ 401(k) plans (plans for business owners with self-employment income and no employees, other than a spouse), 403(b) plans (tax exempt private employers like hospitals and public schools) and 457(b) plans (employees of state and local governments.) Unfortunately, the rules tend to be different for each type of business sponsored savings plan. Things get even more complicated if an individual participates in more than one of these different types of savings plans, since the contribution limits of each separate plan must be accommodated, some with limitations, others without. Additionally, if the employer-sponsors of two separate savings plans are ‘related or affiliated,’ then the two plans, e.g. a SEP IRA by one with its $57,000 contribution limit and the other, a SIMPLE IRA with its $13,500 contribution limit, can cause tremendous confusion as the plans must be considered together for contribution limitation purposes.