SEP stands for “Simplified Employee Pension.” It is generally considered the best choice for sole proprietors and the self-employed. Businesses of any size, including self-employed individuals, can set up these plans, and only the employer can contribute. Contributions are tax deductible and go into a traditional IRA held in the employee’s name. The funds in a SEP IRA remain tax-deferred until you withdraw them in retirement.
You can contribute up to 25% of your net earning from self-employment, up to $53,000. This is one of the big advantages of an SEP IRA over a traditional or Roth IRAs, which have lower contribution limits. SEP IRAs are also easy to set up and operate, involve low administrative costs, and allow for flexible annual contributions (helpful if your cash flow is erratic). In-service withdrawals are allowed, but they will be treated as income and subject to a 10% additional tax. Employees always have total ownership over their SEP IRA funds.
SIMPLE stands for “Savings Incentive Match Plan for Employees.” SIMPLE IRAs are traditional IRAs that are geared towards small businesses and the self-employed. Contributions are tax deductible and not taxable until withdrawal. In this plan, individual employees are able to make salary reduction contributions of up to $12,500 in 2016.
SIMPLE IRAs are also distinguished from SEP IRAs in that employers are required to make contributions on the employee’s behalf -- either a 2% fixed or 3% matching contribution. SIMPLE IRAs have higher contribution limits than traditional and Roth IRAs and they are more cost-effective than many other workplace retirement plan options. Employees are always fully vested in their funds, and have the same in-service withdrawal policy as SEP IRAs.
This plan functions similarly to the 401(k) plans offered by most large businesses, but is only available to people who are self-employed and do not have employees. Individuals (and their spouses, if they earn money from the business) make contributions, and the money grows tax-deferred until they are ready to withdraw. Individual 401(k)s are also available in the Roth version, where contributions are made after taxes, and the funds grow tax-free and are not taxed upon withdrawal.
Unlike SEP and SIMPLE IRAs, individual 401(k)s allow you to borrow against your savings. Money withdrawn early comes with a penalty, unless it is considered a “hardship withdrawal.” While individual 401(k)s require jumping through more hoops to get up and running, they do make it easier to save large amounts of money. Also keep in mind that fees vary widely among 401(k) providers.
Each of these options has unique pros and cons, but each helps people who are self-employed ensure that they have enough money to have a healthy, happy, stress-free retirement.