What is a SIMPLE IRA?
A SIMPLE (Savings Incentive Match Plan for Employees) IRA is a retirement plan for business owners with fewer than 100 employees. It’s essentially a cheaper, simpler alternative to setting up a 401k plan for small businesses.
Unlike other business retirement plans like the SEP IRA and solo 401k, which provide more benefits for the business owner, a SIMPLE IRA is mainly set up with the intention of offering a retirement plan for employees of a business. Employees can contribute to their plans using pre-tax dollars, and employers are required to make mandatory contributions for each eligible employee.
How does a SIMPLE IRA work?
Employees can invest a portion of their salary as pre-tax contributions and receive a deduction on their taxable income. Contribution limits are lower than a standard 401k plan, but the advantage of a SIMPLE IRA is that all employees receive mandatory contributions from their employer.
Employers are required to make contributions each year into their employees’ accounts and can choose one of two options.
- Make non-elective contributions equal to 2% of an employee’s compensation based on a maximum salary of $305,000 in 2022 and $330,000 in 2023.
- Make matching contributions up to 3% of an employee’s compensation, not limited by any compensation limits.
In option 1, an employer needs to contribute 2% of an employee’s salary whether the employee contributes to the plan or not. If an employee makes $100,000 then the employer must contribute $2,000 into their accounts.
In option 2, an employee is required to contribute to their plans in order to receive matching contributions by their employer. If an employee makes, $100,000 they can receive employer contributions up to $3,000 (3% of compensation) by contributing at least that amount themselves.
Unlike a SEP IRA, where contributions are optional, employer contributions are mandatory with a SIMPLE IRA. You cannot choose to skip contributions even if you’ve had a down year.
Who is eligible to receive a SIMPLE IRA?
Employers: Any business owner with fewer than 100 employees can set up a SIMPLE IRA. The business must not have any other retirement plans like a SEP IRA, solo 401k, or 401k. If the business grows to over 100 employees, the SIMPLE IRA can remain open for at least two years. If after two years, the business still has over 100 employees, the business is no longer eligible for a SIMPLE IRA.
Employees: Any employee who made at least $5,000 in compensation in any of the two previous years and are expected to make at $5,000 in the current year are eligible to receive employer contributions to their SIMPLE IRA. Employers can also choose to reduce or eliminate the $5,000 requirement.
SIMPLE IRA contribution limits
Employee can contribute up to $14,000 ($17,000 if age 50+) in 2022 and $15,500 ($19,000 if age 50+) in 2023.
In comparison, a 401k plan has a contribution limit of $20,500 ($27,000 if age 50+) in 2022 and $22,500 ($30,000 if age 50+) in 2023. While the contribution limits are lower than the 401k, employees receive mandatory contributions from their employer with a SIMPLE IRA, whereas employer contributions are optional with a 401k.
SIMPLE IRA benefits and downsides
SIMPLE IRAs are mainly set up to offer retirement benefits for a business’ employees. Employers cannot save as much for retirement with a SIMPLE IRA as they could with other business retirement accounts like the SEP IRA and solo 401k.
The benefit for employers is that a SIMPLE IRA provides a simpler, more cost-effective alternative to setting up a 401k plan at their companies. Employer contributions made to employee SIMPLE IRAs are also tax deductible, which can lower the business’ taxable income.
The downside is contributions are mandatory each year, which can put a strain on some business owners if they have a down year.
The biggest advantage for employees in a SIMPLE IRA is that employer contributions are mandatory, and any contributions received are vested immediately. Employee contributions to their plan are tax deductible and can be contributed to in addition to other retirement accounts like a traditional or Roth IRA.
The downside is that contribution limits are lower than a 401k plan, and there is no Roth option available with a SIMPLE IRA.
SIMPLE IRA withdrawal rules
Like with most other retirement plans, the eligible withdrawal age is 59½. Withdrawals made before the age of 59½ are subject to a 10% penalty plus income taxes on the withdrawn amount. If the SIMPLE IRA is less than two years old, there’s an additional 15% penalty applied on top, bringing the total penalty to 25%.
Qualified withdrawals are penalty-free, but since contributions were made as pre-tax, they’ll be subject to regular income taxes.
Required minimum distributions (RMD)
A SIMPLE IRA has required minimum distributions. Participants must start taking distributions from their accounts when they reach the age of 72. Failure to take an RMD will result in a 50% penalty on the amount that was required to be withdrawn. RMD amounts can be calculated here.
SIMPLE IRA vs SEP IRA vs solo 401k
Generally, if a business has no employees, the solo 401k is the most tax advantaged retirement plan option for business owners. It has the highest contribution limits ($61,000 for 2022), a Roth option, and the ability to invest in any asset class, including alternative assets like crypto and real estate. The downside is that to be eligible for a solo 401k, the business must have no full-time W-2 employees that work over 1,000 hours per year.
If a business has just a few full-time employees, a SEP IRA is likely the next best alternative. It has the same contribution limits as a solo 401k at $61,000 but there’s no Roth option. The downside of a SEP IRA is that if an employer contributes to their SEP IRA, they must also make equal percentage contributions to every eligible employee’s SEP IRA as well.
For example, if an employer has 10 full-time employees, and decides to contribute 20% of their compensation into their SEP IRA, they must also contribute 20% of every employee’s compensation into their SEP IRAs. As a result, a SEP IRA can get very expensive if there is a high employee count at the company.
Both the solo 401k and SEP IRA are mainly geared towards offering tax benefits to the business owner. A SIMPLE IRA starts to seem more attractive when there are dozens of employees at the company and the business owner wants to provide them a retirement plan (without spending too much money and time on administration as a 401k plan would need).