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Small businesses tend to avoid retirement plans, largely due to their complexity and cost. Just 26 percent of small businesses offer 401(k) plans, according to a recent survey by ShareBuilder 401k. Nearly 60 percent of the survey respondents believe their business is too small to qualify for one, while about one-third 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.
Like a traditional retirement plan, the SIMPLE IRA allows employees to have wages deducted from their paycheck. Employees can defer up to $14,000 in 2022. Those over age 50 can defer an additional catch-up contribution of $3,000. 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 $305,000 for 2022.
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 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.
In terms of distributions, a 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 age 59½ or some other exception.
Funds in a SIMPLE IRA must eventually be withdrawn under the IRS’s required minimum distribution (RMD) rules. The SECURE Act has raised the age for RMDs to 72.
Pros and cons of SIMPLE IRAs
- Employees are fully vested as soon as they start saving, so any employer contribution becomes theirs immediately.
- While employees can’t deduct their SIMPLE IRA contributions on their tax returns, the contribution is not reported as income, so effectively employees are able to contribute with pre-tax income.
- Earnings can grow tax-deferred until they’re withdrawn.
- Lower setup costs than a 401(k) and a low amount of administrative management is needed.
- There isn’t a Roth option for SIMPLE IRAs that allows employers and employees to make tax-free withdrawals during retirement.
- 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 at all times.
- 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, 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, whereas a SIMPLE IRA has no required annual tax filing and relatively low fees. Also, investment options are more limited in a 401(k) plan and are chosen by the employer and a plan administrator.
One major bonus of 401(k) plans is that they can come with a Roth option that allows you to make pre-tax contributions and tax-free withdrawals during retirement.
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.