SIMPLE IRA: What It Is & How It Works

SIMPLE IRA written on a piggy bank.

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What Is a SIMPLE IRA?

“SIMPLE” stands for Savings Incentive Match Plan for Employees, and “IRA” stands for Individual Retirement Account. A SIMPLE IRA allows both an employee and an employer to contribute to an IRA on behalf of the employee.

For employees, participating in a SIMPLE IRA plan can provide a source of income at retirement and, for employers, setting up a SIMPLE IRA plan has lower start-up and operating costs than a 401k.

How Does a SIMPLE IRA Work?

Both the employee and the employer contribute a percentage of the employee’s pre-tax salary to a SIMPLE IRA account, and that money grows tax-deferred until it is distributed once the employee reaches age 59.5. Distributions are then treated as ordinary income and taxed as such.

SIMPLE IRAs are set up through financial institutions, such as banks, savings and loan associations, insurance companies, certain regulated investment companies, federally insured credit unions, and brokerage companies. The financial institution will offer several investment choices including stocks and bonds as well as mutual funds.

Employer Rules for a SIMPLE IRA Plan

  • No other retirement plan: An employer must not have any other retirement plan in place, and employer contributions are mandatory; it is this fact that differentiates SIMPLE IRA plans from other employer-sponsored retirement plans.
  • Maximum 100 employees: employers must have 100 or fewer employees, however, those who cross that mark but already have a SIMPLE IRA plan in place may continue with it for two additional years.
  • Contributions: employers must make a matching contribution of either up to 3% of an employee’s annual compensation with no limit on that compensation, or they must make a 2% non-elective contribution for each eligible employee up to an annual limit of $305,000 for 2022.

For example, in the first case an employee receiving a yearly salary of $50,000 and who contributes 5% of their compensation, or $2,500, to a SIMPLE IRA, would receive a matching contribution from their employer of $1,500, which is 3% of $50,000. The total contribution to the employee’s SIMPLE IRA account would be:

$2,500 + $1,500 = $4,000

In the second case, an employee earning $40,000 and who chooses not to make contributions to his SIMPLE IRA will still receive $800 a year, or 2% of $40,000, from his employer. A non-elective contribution is one that is made regardless of whether the employee makes a contribution of their own, and it isn’t deducted from the employee’s salary.

SIMPLE IRA Pros & Cons for Employers

An employer, a sole proprietor, or someone who is self-employed must first decide which type of SIMPLE IRA plan to set up. To allow employees to choose the financial institution where their SIMPLE IRA account will be held, an employer must fill out IRS Form 5304-SIMPLE. If the employer wants to choose the financial institution, they must fill out IRS Form 5305-SIMPLE.

Advantages

  • Lower costs: setting up a SIMPLE IRA plan has lower start-up and operating costs than setting up a 401k plan.
  • Tax deductions: employers get a tax deduction for their contributions to employees’ accounts.
  • Filing requirements: an employer generally has no filing requirements.
  • Employee non-participation: for employers who choose the 3% option, if an employee doesn’t contribute, the employer doesn’t have to contribute either.
  • Percentage reduction: employers can reduce the 3% contribution to a minimum of 1%, but for no more than two out of five years.
  • Automatic enrollment: employees are automatically enrolled in a SIMPLE IRA plan unless they affirmatively choose either not to participate or to contribute a different amount; these automatic enrollment contributions qualify as elective deferrals.
  • Employee exclusions: an employer can exclude from their SIMPLE IRA plan employees receiving retirement benefits through their union and nonresident alien employees who do receive U.S. wages, salaries, or other personal services compensation from the employer.

Disadvantages

  • Mandatory contribution: if an employer chooses the 2% contribution option, they must contribute to an employee’s account whether that employee contributes or not.

Employee Rules & Requirements for a SIMPLE IRA Plan

Employees must fill out a SIMPLE IRA adoption agreement in order to open their accounts. Employees are not required to make regular IRA contributions to their SIMPLE IRA account.

1. SIMPLE IRA Eligibility

All employees, sole proprietors, or the self-employed who received at least $5,000 in compensation during any of the two preceding calendar years and who are expected to receive at least $5,000 during the current calendar year are eligible to participate in a SIMPLE IRA plan.

2. SIMPLE IRA Contribution Limits

In 2022, an employee can contribute an annual maximum of $14,000 into a SIMPLE IRA. However, employees over the age of 50 can make an additional catch-up contribution of up to $3,000, bringing their total contribution to $17,000 per year. Compare that with the 401k plan catch-up contribution in 2022 of $6,500.

SIMPLE IRA Pros & Cons for Employees

Advantages

  • Simplicity: once an employee signs up for a SIMPLE IRA plan, they choose a contribution amount and what investments they want to make. Contributions are then made automatically through payroll with nothing else required of the employee.
  • Transferable: funds in a SIMPLE IRA can be rolled over into another employer’s SIMPLE IRA plan, and as of December 2015, SIMPLE IRA accounts are permitted to accept transfers from SEP IRAs, traditional IRAs, and employer-sponsored plans such as 401k plans.
  • Vesting: there is no waiting period for vesting, and employees have 100% ownership of the amount in their account.
  • Reduce taxable income: contributions are tax-deferred, reducing an employee’s taxable income for the year, and investment growth is tax-deferred until distributions start.
  • Low eligibility requirements: anyone who received a minimum of $5,000 in compensation during any of the two preceding calendar years and if they expect to earn at least that much during the calendar year of participation can participate in a SIMPLE IRA plan, this can be a real boon to part-time employees.
  • Other plan contributions: the IRS allows employees to contribute to other retirement savings plans, such as Traditional IRA or Roth IRAs, at the same time they are contributing to a SIMPLE IRA plan.
  • Annual election period: employees are allowed to change their contribution levels each year during the SIMPLE IRA plan’s election period which must be at least 60 days long.
  • Termination: employees can terminate their contributions to a SIMPLE IRA plan at any time.
  • More investment choices: SIMPLE IRAs offer a greater number of investment choices than those offered by 401k plans which are primarily limited to mutual funds.

Disadvantages

  • Lack of employer contribution: for an employer who has chosen the 3% option, if an employee chooses not to make any contributions himself or herself, the employer will not make any matching contributions.
  • Lower savings: SIMPLE IRA contribution limits are lower than other workplace retirement plans, with a limit in 2022 for those under age 50 of $14,000 per year versus $20,500 for a 401k plan, and for those 50 or older of $17,000 versus $27,000 for a 401k plan.
  • Limited rollovers: a SIMPLE IRA cannot be rolled over into a Traditional IRA without a waiting period of two years from the date on which the employee first participated in the plan; SEP IRAs and Traditional IRAs cannot be rolled over into a SIMPLE IRA.
  • Early withdrawal penalties: for those less than 59.5-years-old, and who have participated for less than two years, an early withdrawal from a SIMPLE IRA comes with a 15% early withdrawal penalty on top of the standard 10% penalty, resulting in 25% of a SIMPLE IRA account’s balance being paid to the IRS, plus income taxes will have to be paid on the money.
  • Income taxes: any amount withdrawn from a SIMPLE IRA and not rolled over, regardless of age, is subject to ordinary income tax for the year in which the distribution is made.
  • No Roth versions: a SIMPLE IRA has no versions of a Roth IRA or a Roth 401k, which means you can’t fund your SIMPLE IRA account with post-tax money and avoid paying taxes when it is withdrawn.
  • No loans permitted: loans from a SIMPLE IRA are not permitted, and the assets may not be used as collateral.

SIMPLE IRA vs. Other Employer-Sponsored Retirement Plans

Besides SIMPLE IRAs, other types of employer-sponsored retirement savings plans include:

  • 401k
  • SEP IRAs
  • 457
  • 403b
  • Profit-sharing plans (PSPs)
  • Employee stock ownership plans (ESOPs)

SIMPLE IRA vs. 401k

The biggest difference between a SIMPLE IRA and a 401k is that for the latter, employer contributions are optional (unless the 401k plan has a “safe harbor” provision) while for the former, they are mandatory. Businesses having over 100 employees cannot offer SIMPLE IRA plans, while any size of employer can offer a 401k plan. Employer contributions to a SIMPLE IRA vest immediately, while with a 401k plan, the employer can set a vesting schedule for their contributions.

The contribution limit for 401k plans in 2022 is $20,500 compared to a limit of $14,000 for a SIMPLE IRA plan. The catch-up contribution for a 401k plan is currently $6,500 for those over age 50.

SIMPLE IRA vs. SEP IRA

A SEP IRA, where “SEP” stands for Simplified Employee Pension, is used by both employers and the self-employed. It differs from a SIMPLE IRA in that a SIMPLE IRA allows both the employer and the employees to make contributions while a SEP IRA allows only the employer to make contributions, both for themselves and for their employees.

A SEP IRA allows up to 25% of income to be contributed tax-deferred. In 2022, a maximum of $61,000 can be placed into each participant’s SEP IRA account. Compare that with the $14,000 maximum for a SIMPLE IRA. SEP IRA account holders are immediately vested, and they can transfer the money in their SEP IRA account to other qualified retirement savings plans or convert it to a Roth IRA, subject to transfer rules between plans.

Bottom Line

SIMPLE IRAs are well-suited for small business owners and for the self-employed due to their low set-up and administration costs, however, employer contributions are mandatory. For this same reason, SIMPLE IRAs are a great way for employees to use employer contributions to grow their retirement savings accounts and a great way for employers to provide their workers with retirement benefits.

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