Should you open a SEP IRA or Simple IRA if you are a one-person business?
This review is for a one-person business whose owner is age 50 or over. It is NOT from the point of view of a small business with a few employees. We will look at which is the better choice under two conditions; when your self-employment income is your primary income and when it’s a secondary income. (The numbers discussed are 2019 limits.)
SEP IRA stands for simplified employee pension individual retirement account. Both the SEP IRA and SIMPLE IRA are defined contribution retirement plans. Both enable you to defer taxes until after retirement.
When investigating or thinking about these types of retirement plans, you need to remember that as a self-employed person you are both the employer and the employee.
The SEP IRA contributions come from your employer side. The SIMPLE IRA contributions are actually employee salary reduction contributions from your employee side.
In 2019, the maximum retirement contributions for the two plans if you are 50 or over are:
SEP-IRA: The lesser of 20% of compensation or $56,000.
SIMPLE: $16,000 for employee contributions plus a SIMPLE IRA employer matching contribution of 3% of compensation up to 3% of $280,000, or $8,400 maximum. Maximum total of $24,400.
Before we go into the details of each scenario, there are two possibilities where your decision is easier.
If there is a chance you will hire employees in the next couple of years, choose a SIMPLE IRA plan.
If you make less than $100,750 per year and you don’t see yourself making more than that from your self-employment income, then choose a SIMPLE IRA plan. (I used this retirement contribution calculator to arrive at the break even number of $100,750. https://www.calcxml.com/calculators/qua12 )
Which should you choose if you have another job?
In this scenario, you have another job and your self-employed income is a secondary income source. Perhaps you drive Uber or have a side business. At your main job you have a 401(k) plan and make the maximum 401(k) contribution of $25,000 every year. You want to defer taxes on as much of your secondary income as possible, to boost your retirement savings.
Remember the picture of two pockets and the fact that as a self-employed person you are both employer and employee? SEP IRA contributions come from the employer side while SIMPLE IRA contributions come from your employee side.
The maximum allowable employee salary reduction contributions are $25,000 total annually, in all such retirement plans. Your 401(k) contribution at your main job comes from this employee side and therefore, you cannot contribute to a SIMPLE IRA if you are already contributing $25,000 to a 401(k).
Since SEP IRA contributions come from the employer side, you could contribute the $25,000 to your 401(k) and also 20% of your self-employed income to your SEP IRA plan.
So, if your self-employed income is a secondary income, you should open a SEP IRA.
What if your self-employed income is your main income?
Since either the SEP IRA or SIMPLE IRA will be your main retirement plan, the decision will come down to which plan has a higher contribution limit.
If you make less than the break even number ($100,750) discussed above, say $50,000 for example, then your maximum contributions to a SEP IRA would be $10,000 and to a SIMPLE IRA would be $17,500. You should choose the SIMPLE IRA because you would be able to save an additional $7,500 tax deferred.
If you make more than the break even point, such as $120,000, then the maximum contribution to a SEP IRA is $24,000 and to a SIMPLE IRA is $19,600. You should choose the SEP IRA.
Is there a significant difference in annual maintenance or IRS reporting requirements?
No. Neither plan requires any reporting to the IRS. The custodian where your accounts are held will take care of all the required paperwork when you open either IRA account.
Impact on Traditional and Roth IRA contributions.
With both the SEP IRA and SIMPLE IRAs, you are still eligible to own and contribute to a Traditional IRA or a Roth IRA. That means you still have the opportunity to contribute another $7,000 for retirement, regardless of which plan you choose.
The 2018 tax write-off decision factor.
The month of the year when you are making this decision may sway you. You can open a new SEP IRA anytime up until you pay your taxes in the following year. So, as I am writing this in February of 2019, you still have until April 17, 2019 to open a new SEP IRA, make contributions for 2018, and therefore get the tax deduction on your 2018 tax return.
The deadline for opening a SIMPLE IRA for 2018 passed on October 1, 2018. You can no longer open a SIMPLE IRA and use it to reduce your 2018 taxes due. If you open a SIMPLE IRA today, the contributions you make will be for 2019.
If you are making this decision or another decision about your retirement plan and would like our help, call us at (760) 651-6315 or email contactus@andrewmarshallfinancial.com.