Small companies tend not to offer 401(k) plans, given the administrative costs and headaches associated with them. So where does that leave employees and owners of small businesses who want retirement benefits?
There’s a type of employer retirement account specifically for small businesses called the Savings Incentive Match Plan for Employees – or, as less of a mouthful, its acronym: the SIMPLE IRA. Here’s what you need to know about it.
What Is a SIMPLE IRA?
Like both IRAs and 401(k) accounts, SIMPLE IRA accounts provide a tax-deferred way to save and invest for retirement. Contributions are pre-tax, meaning they come off employees’ adjusted gross income. In other words, the income you contribute to a SIMPLE IRA is not subject to income taxes. And, as with IRAs and 401(k)s, the IRS imposes contribution limits each year on SIMPLE IRAs.
Yet despite the name, SIMPLE IRAs share more in common with a 401(k) than a traditional IRA.
How SIMPLE IRAs Differ From Other IRAs
First and foremost, traditional IRA accounts are created and maintained by the employee. The employee owns the account in every way. By contrast, SIMPLE IRA accounts are employer-sponsored accounts, typically created and maintained by the employer. Normally, the employer chooses a brokerage, such as Schwab or Vanguard, to hold employees’ SIMPLE IRA accounts. That isn’t always the case, though; the employer can opt to leave it up to employees to open and maintain their own SIMPLE IRA accounts.
The contribution limits are also higher for SIMPLE IRAs than for traditional and Roth IRAs. For the tax year 2021, the contribution limit for SIMPLE IRAs is $13,500 for taxpayers under 50, and taxpayers over 50 can make an extra catch-up contribution of $3,000, for a total limit of $16,500. Contrast that with $6,000 for traditional and Roth IRAs with a $1,000 catch-up option for taxpayers over 50.
Speaking of Roth IRAs, there is no Roth option for SIMPLE IRAs. That means you can’t opt to pay taxes on the contributions now and take the earnings tax-free in retirement.
Contributing to Both an IRA & a SIMPLE IRA
Modest-income taxpayers can contribute to both a traditional or Roth IRA and a SIMPLE IRA through a broker like TD Ameritrade. The same IRS contribution rules apply to both SIMPLE IRAs and 401(k)s when combined with traditional or Roth IRAs. Above a certain income, your ability to contribute to both an IRA and an employer-sponsored retirement plan phases out, and at a certain level, it disappears entirely; see IRS deduction limits here.
How SIMPLE IRAs Differ From 401(k)s
As an employer-sponsored plan, SIMPLE IRA accounts are a cheaper, more flexible alternative to 401(k)s for small businesses with fewer employees. Employers contribute money, but without the administrative headaches and fees that come with 401(k)s.
One similarity worth noting between SIMPLE IRAs and 401(k)s is the income cap on employer contributions. Employers can only contribute based on the first $280,000 of an employee’s income; after that, all obligation ends on the part of the employer.
However, employee contribution limits for SIMPLE IRAs, as outlined above, differ from those for 401(k)s. Employees can contribute more to 401(k) accounts – up to $19,500 per year for employees under 50 or $26,000 per year for employees over 50.
And the differences don’t end there.
1. Contribution Requirement
With a 401(k), employers are not obligated to contribute any money to their employees’ retirement savings. That’s not so with SIMPLE IRAs. For these accounts, employers are legally required to offer one of two contribution plans for employees:
- A “nonelective” contribution equaling 2% of the employee’s salary, no strings attached.
- A matching contribution of up to 3% of the employee’s salary. If the employee doesn’t contribute, the employer doesn’t contribute.
With the latter, the employer can opt to only match 1% of the employee’s contributions for two out of five consecutive years. That’s a particularly useful caveat for startups tight on cash in their early years.
The contribution requirement applies to all employees earning $5,000 or more in each of the last two years who have a “reasonable expectation” of earning over $5,000 this year. For 401(k) accounts, employers typically require one year’s service – the legal minimum – rather than two. Employers must include SIMPLE IRA coverage for part-time employees earning $5,000 or more, not just full-time employees.
Two other exceptions exist: Employers can exclude employees who receive benefits under a collective bargaining agreement and nonresident alien employees who received no U.S. source income.
2. Rollover Restrictions
Unlike with a 401(k), employees must have participated in a SIMPLE IRA account for at least two years in order to roll it over to a different type of retirement account, such as a traditional IRA or 401(k). If they’ve participated for less than two years when they change jobs, they can only roll over funds to another SIMPLE IRA account.
That makes it tricky for employees moving to a new company that doesn’t offer a SIMPLE IRA. After all, forgetting about past employers’ retirement accounts is a classic retirement planning mistake to avoid.
Fortunately, once two years have passed since the first contribution to a SIMPLE IRA, employees can then roll over the funds to a different type of retirement account – with the exception of a Roth IRA since there is no Roth option for SIMPLE IRA accounts.
If you’re trying to roll over funds after changing jobs, read up on the rollover process for SIMPLE IRA accounts.
3. Greater Investment Flexibility
One drawback of 401(k) plans is that employees are stuck with whatever investment options the plan administrator offers. But since employees open SIMPLE IRA accounts directly with a brokerage, they can choose their own investments, such as stocks, bonds, mutual funds, and ETFs. Most brokerages allow employees broad flexibility to choose investments. Employees can even invest in target-date funds in most cases, relieving them of worrying about shifting their asset allocation as they approach retirement.
4. Easier & Cheaper for Both Employees & Employers
Instead of hiring a 401(k) plan administrator, employers can simply open accounts with a brokerage. That means they can avoid both the initial setup fee and, in some cases, ongoing maintenance fees. For example, Charles Schwab charges no monthly or annual fees for SIMPLE IRA accounts. That’s a stark contrast to 401(k) fees, which can be high for both employers and employees.
There is one drawback to keep in mind: Unlike with a 401(k), employers must set up a separate account for each employee – if they take on the responsibility of opening the accounts, that is. Employers can opt to let employees open their own SIMPLE IRA accounts. In that case, all employers have to do is fund the accounts each payroll cycle.
5. Higher Penalties for Early Withdrawal
When you take an early withdrawal or distribution from your retirement account before age 59½, the IRS frowns upon it. It then slaps you with both a 10% penalty and the full income taxes due on the money you withdrew. That applies to IRAs, 401(k)s, 403(b)s, and SIMPLE IRAs.
But SIMPLE IRAs don’t stop there. If you take a distribution before you turn 59½ and within the first two years of participating in your SIMPLE IRA plan, the penalty increases from 10% to 25%.
There are a couple of exceptions to this penalty. You can avoid it if:
- You incur non-reimbursed medical expenses and use the withdrawal to cover them.
- You receive the SIMPLE IRA account from someone who died.
6. Company Size Restrictions
Unlike a 401(k), SIMPLE IRA accounts are only for small businesses. Companies must have under 100 employees to qualify as small enough to offer a SIMPLE IRA – specifically, 100 eligible employees who earn $5,000 or more each year. Employees earning under $5,000 per year don’t count toward the cap, nor do independent contractors. Anyone paid via 1099 also doesn’t count toward the employee limit.
Similarly, small-business owners aren’t obligated to pay SIMPLE IRA contribution benefits to independent contractors, unlike part-time employees.
7. No Loans Allowed
While many 401(k) administrators allow employees to borrow money from their 401(k) accounts, the same is not true of SIMPLE IRAs. They share this feature with traditional IRAs. So don’t count on pulling money from your SIMPLE IRA in a pinch without incurring distribution penalties.
Creating a SEP IRA vs. a SIMPLE IRA
For self-employed workers and small companies with only a few employees, a SEP IRA may be a better choice. That’s because the contribution limit for SEP IRAs is a whopping $58,000 per year. Even though self-employed people can contribute $13,500 on the employee side and up to another $13,500 on the employer profit-sharing side for SIMPLE IRAs, the contribution limit for SEP IRAs is still more than double that. Prior year contributions are also allowed in SEP IRAs, unlike with SIMPLE IRAs.
Before deciding between a SEP IRA and a SIMPLE IRA, speak with your tax preparer or another financial advisor.
5 Steps to Create a SIMPLE IRA
Interested in moving forward with a SIMPLE IRA retirement savings plan for your small business? Here are five quick steps to follow.
Step 1: Confirm Eligibility
As long as you have fewer than 100 employees earning $5,000 per year or more, your business qualifies. It’s as simple as that.
Step 2: Pick a Provider
Choose a brokerage firm that offers SIMPLE IRA accounts. Notable examples include TD Ameritrade, T. Rowe Price, Fidelity, Vanguard, Charles Schwab, Edward Jones, and most other big-name brokerage firms.
Make sure you clearly understand the fee structure before committing. For example, Vanguard charges $25 per account per year but waives the fee for high-value accounts. As mentioned above, Schwab doesn’t charge a maintenance fee on SIMPLE IRA accounts.
Step 3: Complete the IRS Forms
The IRS wouldn’t be the IRS if they didn’t make you fill out forms.
While your brokerage provider will have their own forms they require you to fill out, you also need to give a specific form to your employees. Which form you need depends on who’s opening the SIMPLE IRA accounts.
- IRS Form 5305-SIMPLE. If you open SIMPLE IRA accounts with the brokerage yourself on your employees’ behalf, use this form.
- IRS Form 5304-SIMPLE. If you have your employees open their own SIMPLE IRA accounts with the brokerage of their choice, use this form.
Employers do not need to file this form with the IRS but should keep copies in case they ever get a call from Uncle Sam.
Step 4: Enroll Your Employees
Typically, your plan provider helps you enroll your employees. They provide the signup and enrollment links, normally handling it all online.
One quirk worth noting, however, is that employers can only set up a SIMPLE IRA during the first three quarters of the year. After October 1st, companies have to wait until the following year if they want to create a SIMPLE IRA.
Step 5: Set Up Contribution Payments
Making payments simply involves setting up direct deposits from payroll for each participating employee. Remember, contributions must be taken out before payroll taxes are processed. Otherwise, it would defeat the entire purpose.
For small businesses, offering employees a SIMPLE IRA is a low-cost, low-headache alternative to a 401(k) plan. With no setup fees and potentially no maintenance fees, the only significant costs to employers are the contributions themselves.
Still, SIMPLE IRAs come with their own rules, requirements, and restrictions, so make sure you understand them all before making any commitments to employees.