A SIMPLE IRA is a retirement savings plan tailored to the needs of small business owners and sole proprietors. Like other workplace retirement plans, both employers and employees can contribute to a SIMPLE IRA and get access to valuable tax benefits.
How Does a SIMPLE IRA Work?
A SIMPLE IRA, also known as a Savings Incentive Match Plan for Employees, lets smaller companies provide their employees with retirement benefits. SIMPLE IRAs are ideal for small business owners because they lack the reporting requirements and the associated paperwork that’s required for many other workplace retirement plans, like 401(k)s.
Both employers and employees can contribute money to a SIMPLE IRA. Employees can choose whether they want to contribute, while employers must make contributions.
Employees may choose to save pre-tax income in their accounts, which provides the benefit of lowering their overall taxable income. Employers make either dollar-for-dollar matching contributions equal to 1% to 3% of their employees’ salary, or nonelective contributions equal to 2% of salary, regardless of whether a worker contributes.
Money saved in a SIMPLE IRA can be invested in a wide variety of different securities and funds, and since it’s a tax-deferred account, you won’t have to pay capital gains taxes when you buy and sell different investments inside your account. Withdrawals in retirement, however, are taxed as normal income, and SIMPLE IRAs are not available as Roth accounts.
Who Can Open a SIMPLE IRA?
To open a SIMPLE IRA, you and your employer must meet certain criteria:
- Employer Eligibility for a SIMPLE IRA. An employer must have 100 employees or fewer to open a SIMPLE IRA, and it must make contributions each year. It can switch between matching contributions and nonelective contributions as long as it provides notice.
- Employee Eligibility for a SIMPLE IRA. Employees may participate in a SIMPLE IRA if they have received at least $5,000 in compensation during any two of the previous calendar years and expect to be paid that much in the current year. Employers may use less stringent requirements, though whatever rules they set must be applied identically to all employees. Employers don’t have to let an employee participate in a SIMPLE IRA plan if they receive union benefits.
SIMPLE IRA Contribution Limits
For 2020 and 2021, the SIMPLE IRA contribution limits are $13,500, or $16,500 for people who are age 50 and older.
If you want to contribute more than that amount, you can also invest up to an additional $6,000 ($7,000 if 50 or older) in a traditional or Roth IRA. You cannot, however, max out both a SIMPLE IRA and another employer-sponsored retirement plan, like a 401(k). The annual total for both SIMPLE IRA contributions and 401(k) contributions can’t be more than $19,500 for 2020 and 2021 ($26,000 if you’re 50 or older). Because an employer cannot offer both a 401(k) and a SIMPLE IRA, this scenario would only occur if you changed employers during one year or your employer changed your plan mid-year.
SIMPLE IRA Withdrawal Rules
Like other tax-advantaged retirement plans, you pay taxes at your marginal tax rate when you withdraw from your SIMPLE IRA in retirement. Withdrawals made before age 59 ½ may be subject to a 10% penalty in addition to any taxes you owe. With a SIMPLE IRA, this penalty rises to 25% if you take the money out within two years of when you first started contributing to the plan.
You may be able to avoid the early withdrawal penalty if you have major unreimbursed medical expenses, have qualified higher education expenses or use what you withdraw to purchase a first home, among other qualified exemptions. You still have to pay the taxes on your early withdrawals, though.
SIMPLE IRA Rollovers
You can rollover SIMPLE IRA retirement funds into another SIMPLE IRA tax and penalty free at any time. You can only do the same with personal IRAs or another type of employer-sponsored plan once you’ve had your SIMPLE IRA open for at least two years. Before then, any rollovers to non-SIMPLE IRAs are considered early withdrawals and you must pay any income taxes plus the 25% early withdrawal penalty.
Note: Regardless of when you roll over funds, you’ll still owe taxes on any money you move into a Roth account due to the accounts’ differences in tax treatments.
SIMPLE IRA Advantages
- Relatively easy to set up and operate. For employers, a SIMPLE IRA is relatively easy to set up and administer. The reporting requirements and other criteria are less onerous than with a 401(k), making it easier for small companies to offer retirement benefits.
- Pre-tax contributions. For employees, contributing to a SIMPLE IRA reduces your taxable income, providing a tax benefit today. Your balance grows tax-deferred over time, and in retirement, you pay taxes on withdrawals at your marginal income tax rate.
- No vesting of employer matching contributions. All money deposited by an employer into your SIMPLE IRA is immediately yours. This kind of immediate vesting does not always happen with other employer-sponsored retirement plans.
- Tax credit for employers: When they set up a SIMPLE IRA, employers can get a tax credit equal to 50% of startup costs, up to a maximum of $500 per year, for three years. This is on top of the other tax benefits they receive when they contribute to employee retirement plans.
SIMPLE IRA vs. 401(k)
For employees, the biggest differences between a SIMPLE IRA vs. 401(k) are the greater contribution limits available with a 401(k). The contribution limit for a 401(k) in 2020 and 2021 is $19,500, or $26,000 for participants who are age 50 or older.
For employers, a SIMPLE IRA requires less administrative work, with fewer compliance requirements and less paperwork. However, employer contributions to all employee SIMPLE IRAs are mandatory and immediately vested to the employee. 401(k)s do not require employer contributions, and those that do offer employer contributions can set a vesting schedule gradually ceding ownership to employees.
If employees leave before their contributions are fully vested, they only get a portion of the employer contribution.
SIMPLE IRA vs. SEP IRA
Any business with one or more employees, including freelancers or a sole proprietorship with one employee, can open a SEP IRA. Like SIMPLE IRAs, SEP IRAs are very easy to set up and administer and offer immediate vesting of employer contributions. Neither SEP IRAs or SIMPLE IRAs are available as Roth accounts.
While employees can contribute to SIMPLE IRAs, SEP IRAs are almost always funded only by employer contributions. SEP IRA employer contributions are limited to the lesser of 25% of employee compensation or $58,000 in 2021 ($57,000 in 2020). Self-employed people may contribute to their own SEP IRAs as their employer, but tthey similarly cannot contribute more than the lesser of $58,000 in 2021 ($57,000 in 2020) or 25% of their net earnings.
Note: If you’re self-employed, you can open a SIMPLE IRA or a SEP IRA, but it might make more sense to open a Solo 401(k) given the potential higher contribution limit and access to Roth tax treatments.
How to Set Up a SIMPLE IRA
Employers can set up SIMPLE IRAs for their employees in two main ways: by partnering with a chosen financial institution that then offers employees individual accounts or by setting up the infrastructure for SIMPLE IRAs and letting workers open their own accounts at different financial institutions.
Employers file different IRS forms to set a SIMPLE IRA depending on whether they opt for a single custodian or let their employees choose different custodians.
- If the employer chooses one custodian, it uses form 5305-SIMPLE.
- If the employer lets employees choose, it uses form 5304-SIMPLE.
If an employee wants to participate, they need to fill out a SIMPLE IRA adoption agreement and then open the account at their employer’s designated institution or one of their own choice, depending on how their employer set up the SIMPLE IRA.
Should You Choose a SIMPLE IRA?
If your employer offers a SIMPLE IRA and you’re eligible for the plan, it’s a good idea to participate, especially if the employer provides matching contributions. Matching contributions are free money, and with a SIMPLE IRA that money is immediately vested on your behalf.
And if you’re an employer with 100 or fewer employees and want to provide an employee retirement benefit, a SIMPLE IRA can be a solid choice that allows you to attract high-quality workers without some of the paperwork and hassle that can come with a 401(k). However, it’s important to review your options and consider whether it makes sense for you. Remember that you’re required to provide some amount of employer contribution as long as you have a SIMPLE IRA retirement plan.
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