What is a SIMPLE IRA and who can have one?

Small businesses tend to avoid retirement plans, largely due to their complexity and cost. Just 28 percent of small businesses offer 401(k) plans, according to a recent survey by ShareBuilder 401k. Nearly 64 percent of the survey respondents believe their business is too small to qualify for one, while about one-fifth say they can’t afford a matching contribution. A SIMPLE IRA may be just what small businesses need to help their employees save for retirement.

What is a SIMPLE IRA?

A SIMPLE IRA offers a straightforward and inexpensive way for small businesses to establish a retirement plan for their employees. A SIMPLE IRA can be a great way to help workers secure their future. And since employers themselves often comprise a significant portion of a small business, a SIMPLE IRA can help them set up their own retirement plan, too. The IRS permits employers (including self-employed individuals) with no more than 100 employees earning more than $5,000 in the preceding year to establish a SIMPLE IRA. Here’s what else you need to know about the SIMPLE IRA.

How a SIMPLE IRA works

While the plan is called an IRA, a SIMPLE IRA is fundamentally different from a traditional IRA or Roth IRA. These latter IRAs are established by workers for themselves, with different annual contribution limits, plan rules, and purposes. Instead, a SIMPLE IRA looks more like a 401(k) program, but it tends to be easier for the company to set up and manage. It’s called SIMPLE – short for Savings Incentive Match Plan for Employees – for a reason.  Employers don’t have to worry about complex federal reporting requirements like they do with 401(k) plans. And they can set up the plan through a financial institution, which operates it. A SIMPLE IRA can be set up as either pre-tax (traditional) or after-tax (Roth). The Roth SIMPLE IRA was just created by the 2022 SECURE Act 2.0, so employers may not offer it yet. If the SIMPLE IRA is traditional, any employee contribution goes into the account before tax. The money can grow tax-deferred for decades and then is taxed as ordinary income when it’s withdrawn at retirement, defined as beginning at age 59 ½. If the SIMPLE IRA is a Roth, the employee contribution goes into the account after tax. Then the money can grow tax-free for decades and will be tax-free when withdrawn from the account at retirement, defined as beginning at age 59 ½.

Contribution limits

Like a traditional retirement plan, the SIMPLE IRA allows employees to have wages deducted from their paycheck. Employees can defer up to $15,500 in 2023. Those over age 50 can defer an additional catch-up contribution of $3,500. These contributions are “elective deferrals” that count toward the total annual limit on elective deferrals to this and other retirement plans. Employers are required to chip in to their employees’ SIMPLE IRA accounts, and they have two options to contribute funds:

• Match workers’ contributions on a dollar-for-dollar basis, up to 3 percent of individual earnings.
• Make non-elective contributions up to 2 percent of wage earners’ compensation up to the annual compensation limit of $330,000 for 2023.

In addition, starting in 2024 employers may contribute an additional voluntary 10 percent of salary, up to $5,000, to each eligible employee earning at least $5,000. The $5,000 voluntary contribution amount is indexed for inflation starting in 2025.

Example of a SIMPLE IRA

Imagine you earn $60,000 a year, and your employer matches the contributions you make for up to 3 percent of your salary. You would like to save a total of 10 percent of your salary, including the match. So you decide to defer 7 percent of your own pay in each paycheck. Over the course of the year, you would save $4,200 in pre-tax or after-tax dollars, while your employer would contribute $1,800, for a total contribution of $6,000. Since you contributed more than 3 percent of your salary, you will have received the full employer match of 3 percent. In this scenario, you had to contribute money in order to receive the employer match. But employers may instead offer a 2 percent non-elective contribution to employees. In this second scenario, all eligible employees would receive a contribution regardless of whether they contributed from their own salary. Based on your salary of $60,000, you would receive a total contribution of $1,200 for the year from your employer. Then you could contribute any additional amount up to the annual contribution limit.

Withdrawal rules

The withdrawal rules for SIMPLE IRAs are the same as for the respective traditional and Roth IRAs. In terms of distributions, a traditional SIMPLE IRA functions like a traditional IRA. Money in the account is subject to tax only when it is withdrawn. While you can withdraw money at any time, a 10 percent tax may apply (as well as a special 25 percent tax in certain circumstances), unless you withdraw the funds after the standard retirement age of 59½ or under some other exception. Money in a traditional SIMPLE IRA must eventually be withdrawn under the IRS’s required minimum distribution (RMD) rules starting at age 73. The distribution rules for a Roth SIMPLE IRA work as they do for a Roth IRA. Money will be tax-free if withdrawn after the retirement age of 59 ½. Contributions may be withdrawn at any time without tax or penalty, but any earnings will be subject to a penalty tax. The Roth SIMPLE IRA has no required minimum distributions and can be held indefinitely.

Pros and cons of SIMPLE IRAs

Pros

• Employees are fully vested as soon as they start saving, so any employer contribution becomes theirs immediately.
• Employees can contribute on a pre-tax basis (traditional SIMPLE IRA) or after-tax basis (Roth IRA).
• Earnings can grow tax-deferred (in a traditional account) or tax-free (in a Roth account) until they’re withdrawn.
• A SIMPLE IRA has lower setup costs than a 401(k), and it requires only a low amount of administrative management.

Cons

• Contribution limits are lower for SIMPLE IRAs than they are for 401(k) plans, but you can still contribute to other retirement plans on your own or through a second job.
• You’ll pay a 25 percent penalty on distributions made before age 59 ½ if it’s within the first two years of your participation in the plan and 10 percent after that. Meanwhile, the maximum that 401(k) plans penalize early withdrawals is 10 percent.
• There are no loans available on SIMPLE IRAs.

SIMPLE IRA vs. 401(k)

While SIMPLE IRAs and 401(k) plans are both useful for saving for retirement, there are some key differences between the two plans. SIMPLE IRAs are unique to small businesses and can only be used by employers with 100 or fewer workers earning no more than $5,000 annually, while 401(k) plans can be opened at any workplace with one or more employees. Employer contributions are optional in 401(k) plans, but mandatory for SIMPLE IRAs. You’ll also have higher contribution limits in 401(k) plans than in a SIMPLE IRA. The fees and administrative tasks involved are higher in 401(k) plans – though they’re relatively easy in a solo 401(k) plan – whereas a SIMPLE IRA has no required annual tax filing and relatively low fees. Also, investment options may be more limited in a 401(k) plan and are chosen by the employer and a plan administrator. Both SIMPLE IRAs and 401(k) plans may come with a Roth option that allows you to make pre-tax contributions and tax-free withdrawals during retirement.

Bottom line

A SIMPLE IRA makes a great option for a small business to set up a retirement plan for its employees, with less hassle and expense than a typical 401(k) plan, and employees can benefit from the tax advantages and matching benefits of the plan. But small businesses have other attractive options, too – a SEP IRA and solo 401(k), both of which can offer higher contribution limits – and it’s important to investigate which plan works best for your situation.