While 401(k) retirement plans have their advantages from the employer’s perspective, they are relatively complex and expensive to set up and tedious and time-consuming to administer.
Due to these drawbacks, smaller companies — those with 100 or fewer employees — have found success in the Savings Incentive Match Plan For Employees (SIMPLE) IRA. Compared with 401(k)s and other conventional retirement plans, SIMPLE IRAs have lower startup and operating costs.
For example, employers offering SIMPLE IRAs do not have any tax filing requirements with the IRS. Moreover, there are no extra paperwork requirements — aside from the initial plan document and annual disclosures — to distribute to employees.
Nevertheless, SIMPLE IRAs have their drawbacks when compared to other retirement plans. Therefore, before considering whether to choose it for its simplicity, it’s wise to have a comprehensive understanding of what’s involved.
What is a SIMPLE IRA?
A SIMPLE IRA is a type of individual retirement account (IRA) that allows employers with 100 or fewer employees to contribute to the retirement funds of their employees without the startup or operating costs of other conventional retirement accounts. Self-employed individuals can also set up and contribute to a SIMPLE IRA.
- Through Matching Contributions
- Here, an employer matches the contribution of an employee to their SIMPLE IRA account. SIMPLE IRA rules require that the employer match should not exceed 3% of the employee’s annual compensation.
For example, an employee named Mr. A — whose annual compensation is $10,000 — contributes $1,000 to his SIMPLE IRA each year. His employer will match that contribution up to $300 (3% of $10,000).
Mr. A can stop such contributions at any time and still enjoy non-elective contributions. However, depending upon the rules of his SIMPLE IRA, he might not be able to resume making his own contributions until the next calendar year.
- Through Non-Elective Contributions
- If an employee chooses not to individually contribute to the plan, SIMPLE IRA rules dictate that the employer must still contribute an amount equal to 2% of the employee’s compensation up to annual limits ($330,000 in 2023).
To continue our example scenario from above, an employee named Mrs. B also earns $10,000 annually but decides not to contribute to her SIMPLE IRA plan. In this case, her employer will still make its own contribution of up to $200 annually to her plan (2% of $10,000).
An employer must contribute to an employee’s SIMPLE IRA in one of two ways:
All the funds held in a SIMPLE IRA are owned by the employee. Moreover, the employee makes the investment decisions for their own account and, if the employer permits, can change the financial institution in charge of the account.
The available investment assets are the same as any other traditional IRA: stocks, bonds, mutual funds, ETFs, REITs and certificates of deposit (CDs).
Those looking to invest in more nontraditional assets, like cryptocurrencies and real estate, might instead consider a self-directed IRA.
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SIMPLE IRA Tax Implications
Any contributions by an employee to a SIMPLE IRA grow tax-free. The contributions are only taxed at the time of withdrawal.
Contributions by an employer to a SIMPLE IRA are tax-deductible. The SECURE Act of 2019 grants a maximum $500 tax credit annually for employers that use a SIMPLE IRA with automatic enrollment. According to the IRS, automatic enrollment allows the “employer to automatically deduct a fixed percentage or amount from an employee’s wages and contribute that to the SIMPLE IRA plan, unless the employee has affirmatively chosen to contribute nothing or to contribute a different amount.”
SIMPLE IRAs vs. Other Popular Retirement Plans
Understanding SIMPLE IRAs requires differentiating them from other similar retirement plans.
First, how do they differ from a 401(k)?
SIMPLE IRAs vs. 401(k)s
|Users||While a SIMPLE IRA is generally only suitable for small businesses with 100 or fewer employees, any business with any number of employees can offer a 401(k).|
|Matching||Employers can decide whether to contribute to a 401(k) plan. Employers who opt for a SIMPLE IRA must contribute. Under a SIMPLE IRA, only the employees have the option not to contribute.|
|Contribution Limits||401(k) plans have higher contribution limits than SIMPLE IRAs.|
|Eligibility||Anyone who is 21 years or older and has worked for a year is eligible for a 401(k). Employees must have earned $5,000 over any two-year period before the current calendar year and must be on course to earning at least $5,000 in the current year to qualify for a SIMPLE IRA.|
SIMPLE IRAs vs. Traditional IRAs
|Set Up||SIMPLE IRAs are set up by employers while traditional IRAs are set up by individuals without regards to their employers.|
|Contributions||Consequently, while both employers and employees can contribute to the former, only employees contribute to the latter.|
|Contribution Limits||SIMPLE IRAs have higher contribution limits.|
|Eligibility||As long as you earn income, you can open and operate a traditional IRA with your custodian. With a SIMPLE IRA, you must make a certain amount of money to qualify.|
What about SEP IRAs? Though alike in many ways, SIMPLE IRAs do carry key differences.
SIMPLE IRAs vs. SEP IRAs
|Matching||Only the employer contributes to a SEP IRA. On the other hand, a SIMPLE IRA allows both employers and employees to contribute. No one is mandated to contribute to a SEP IRA, while employers are mandated to contribute to a SIMPLE IRA.|
|Contribution Limits||SEP IRAs have higher contribution limits when compared to SIMPLE IRAs.|
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Establishing a SIMPLE IRA
Before taking the steps to set up a SIMPLE IRA, let’s spend some time looking at the conditions you must meet.
Who Can Set Up a SIMPLE IRA Plan?
SIMPLE IRAs were designed for smaller businesses who can’t deal with the cost — in money and time — associated with other conventional retirement plans. Therefore, a company with more than 100 employees cannot use it. Also, once an employer operates SIMPLE, they can’t operate another retirement plan concurrently.
On the other hand, an employee can generally only qualify for a SIMPLE IRA if they meet two conditions: they have earned at least $5,000 during any two-year period preceding the current calendar year (the year the SIMPLE IRA is being created) and they expect to earn at least $5,000 in the current calendar year.
These conditions for employees are not set in stone. According to the IRS, the employer can relieve these conditions (for example, they might require $3,000 instead of $5,000) but cannot intensify them (for example, require $10,000 instead of $5,000).
In addition, the employer can exclude two categories of people for reasons that have nothing to do with income:
- Employees already covered by a union agreement, provided there was a good-faith negotiation of retirement benefits between the employer and the union.
- Non-resident alien employees who do not have U.S. wages, salaries or compensation from other personal services.
Setting Up a SIMPLE IRA Plan
- Fill Out a Form From the IRS
- Setting up a SIMPLE IRA is as easy as completing a form available on the IRS website. You can fill the Form 5304-SIMPLE if you want your employees to choose their own trustee (financial institution) or the Form 5305-SIMPLE if you want to choose a financial institution for them.
- Request a Prototype From Your Financial Institution
- Alternatively, you can request a SIMPLE IRA prototype — a specially drafted IRA plan agreement — from the financial institution of your choice. Many financial institutions are pre-approved by the IRS to open the accounts.
Employers can set up a SIMPLE IRA in two ways:
After setting up the plan, an employer must inform all eligible employees of its existence and plan details.
The employer then opens a SIMPLE IRA plan account for every eligible employee using either Form 5305-S (SIMPLE Individual Retirement Trust Account) or Form 5305-SA (SIMPLE Individual Retirement Custodial Account).
Once the accounts have been created, employers are mandated to provide annual disclosures to their employees before the election period. In IRA parlance, the traditional election period is the minimum 60-day period (November 2 through December 31) before the beginning of a new calendar year. However, the election period can change if an employer opened their SIMPLE IRA plan in the middle of the year, or if the 60-day period falls before the first day an employee became eligible to participate in the SIMPLE IRA.
Regardless of the election period, employers must provide all employees with the following information before the beginning of that period:
- They can choose to contribute to their SIMPLE IRA or change the amount they are already contributing.
- They can select the financial institution of their choice (provided that the option is available).
- Whether the employer will make matching or non-elective contributions.
- A summary description of the current state of the plan as provided by the relevant financial institution.
- They can transfer from one SIMPLE IRA plan to another without cost or penalty. For example, if they already have a SIMPLE IRA somewhere else, they can transfer it to the current employer’s plan.
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The Rules Guiding SIMPLE IRAs
Like every other retirement plan, SIMPLE IRAs have their own rules set by the IRS. Below are some of the most important SIMPLE IRA rules to be familiar with:
Early Withdrawal Penalties
The withdrawal age for a SIMPLE IRA is the standard 59 ½ years. Any withdrawals before that will incur a 10% withdrawal penalty. However, the penalty grows to 25% if the withdrawal occurs within the first two years of first participation in the plan.
Required minimum distributions (RMD) also set in by age 72.
For employees who choose to contribute to the plan, contributions must be made within 30 days after the end of the month in which the amounts would have become payable to them.
On the other hand, the employer must make contributions before the due date for filing business income tax returns (including any applicable extensions).
In 2023, employees can contribute a maximum of $15,500 to a SIMPLE IRA. For employees 50 years old and above, there is a catch-up contribution of $3,500 that increases their limit to $19,000.
These contribution limits are adjusted every year to cater to cost-of-living adjustments (inflation).
Benefits and Drawbacks of SIMPLE IRAs
SIMPLE IRAs offer benefits that can make them attractive for employers and employees alike.
These benefits include:
- They are easy, quick and inexpensive to set up. SIMPLE IRA plans don’t require any extensive documentation or filing with the IRS. Operating a SIMPLE IRA is also fairly seamless and requires only sending annual disclosures to employees.
- Employers and employees can each contribute. The matching contribution feature allows both employers and employees to contribute to the retirement savings of the latter.
- They offer flexibility for employees. Employees can choose their custodian or trustee if their employer permits. They can also change their custodian or trustee during an election period. Finally, employees have control over the assets they invest in.
It’s imperative to also consider some SIMPLE IRA cons:
- They offer low contribution limits. The contribution limits of a SIMPLE IRA are lower, for example, than those of a 401(k) or a SEP IRA.
- Conditional rollover from other plans. While they can migrate from one SIMPLE IRA to another, employees must wait two years from the time they started the plan before rolling over funds from a SIMPLE IRA to a traditional IRA. The IRS defines many stipulations for the rollover and transfer process.
- They can be limiting. A glaring limitation is that employers cannot offer any other retirement plan. There is also no option for a Roth plan with a SIMPLE IRA. Further, employees cannot take out a loan or hardship withdrawal from their SIMPLE IRA as they can with other types of retirement accounts.
- They carry compulsory contribution rules for the employer. Even when employees are not contributing, the employer must contribute up to 2% of the employee’s annual compensation to the account.
So, is a SIMPLE IRA right for you? As an employer or employee, you need to weigh the benefits and drawbacks and compare them to other common retirement plans before making a choice.
As with every other important financial decision, ensure you talk to your financial advisor before making a final decision.