A SIMPLE IRA — short for Savings Incentive Match Plan for Employees — is a type of retirement account that allows both employers and employees to contribute money for retirement.
Thanks to their reduced operating costs, SIMPLE IRAs are a popular retirement savings tool for small businesses that may not have enough employees to justify a more robust 401k plan. And not only are SIMPLE IRA plans a useful tool for small businesses with employees, but they also allow self-employed individuals to save for their own retirement, even if they don’t have any employees.
Wondering whether a SIMPLE IRA is right for you or your business? Keep reading to learn how a SIMPLE IRA works, who can participate, and some of the pros and cons you should know about.
How Does a SIMPLE IRA Work?
A SIMPLE IRA plan is available to any employer with 100 or fewer employees who earned $5,000 or more in the previous year. Additionally, this type of plan is only available to employers that don’t have another retirement plan in place.
Under a SIMPLE IRA plan, an employer is required to make one of two types of contributions. First, they can make a matching contribution of up to 3% of compensation. They can instead make a 2% nonelective contribution for each eligible employee. Employees may also choose to contribute to their own accounts. Though under the nonelective contribution, the employer must make a contribution regardless of whether the employee contributes.
In most cases, matching contributions must equal 3%. But employers can reduce that amount as long as they contribute at least 1% of an employee’s compensation and don’t reduce contributions below 3% for more than two years in the previous five years.
There is a limit as to how much employees can contribute to their own SIMPLE IRAs each year. In 2021, the maximum contribution is $13,500, with an additional $3,000 catch-up contribution for employees age 50 or older.
One feature of SIMPLE IRA plans that’s different from many other employer-sponsored retirement plans is that employees are 100% vested as soon as they participate in the plan. In the case of a 401k plan, on the other hand, an employee might contribute to their own plan for several years before they become vested and take ownership of their employer’s contributions.
The withdrawal requirements for SIMPLE IRAs are similar to other types of retirement accounts. Participants generally can’t withdraw funds until they reach 59½, and if they withdraw early, they’ll pay a 10% penalty. Withdrawals within the first two years of participating in the plan will have an increased penalty of 25%. Additionally, because the money isn’t taxed when it’s deposited into the SIMPLE IRA, participants will pay income taxes on the funds when they withdraw them.
Employees can decide to roll their funds over into an IRA that’s separate from the SIMPLE IRA plan, but only after they’ve been participating in the plan for at least two years.
Who Can Participate in a SIMPLE IRA Plan?
When an employer sets up a SIMPLE IRA, they’re required to make it available to all employees who received at least $5,000 in compensation during the past two calendar years and who are expected to receive at least $5,000 in the current year. Employers can make their plan eligibility requirements less restrictive, but not more restrictive.
There are a few situations where employers can exclude certain employees from their SIMPLE IRA plans, including if the employee is covered by a collective bargaining agreement or if they’re a nonresident alien who received no U.S. source earned income.
Not only are employers required to contribute to the SIMPLE IRAs of employees who meet the eligibility requirements, but those employees can’t opt out. Instead, the employee can simply choose not to make their own contributions. It’s important to note that if an employer offers matching contributions and an employee chooses not to contribute, then the employer won’t have to contribute either.
How Are SIMPLE IRAs Established?
The process of establishing a SIMPLE IRA isn’t difficult. In fact, the simplicity of these plans is what makes them attractive for so many small businesses.
In most cases, employers can set up a SIMPLE IRA to be effective any time between January 1 and October 1, with a few exceptions. First, new employers who come into existence after October 1 can set up their SIMPLE IRA to be effective immediately. On the other hand, employers who previously maintained a SIMPLE IRA and are re-establishing one can’t have a start date until January 1 of the following year. In any case, employers can’t set up a SIMPLE IRA with an effective date before they adopt the plan.
To set up a SIMPLE IRA, there are two different forms you can use:
Form 5304-SIMPLE: This form should be used by companies who plan to permit their employees to choose the financial institution where their contributions will go.
Form 5305-SIMPLE: This form should be used by companies who plan to designate a financial institution where all plan contributions will go.
Both forms require employers to share critical plan information about employee eligibility requirements, salary reduction agreements, contributions, and other provisions. Once the form is completed and you’ve signed it, the SIMPLE IRA form is up and running. It doesn’t have to be filed with the IRS.
No matter what form an employer uses, they’ll also have to create a written agreement that informs their employees about the plan. Additionally, they must provide their employees with annual notice about any changes to the plan and contributions.
In addition to setting up the SIMPLE IRA plan, the company also has to set up the SIMPLE IRA accounts for each plan participant. These accounts are where contributions will be deposited. It’s important to note that SIMPLE IRA plans cannot deposit funds into Roth IRAs.
Remember that once the SIMPLE IRA is up and running, the employer is required to make either matching or fixed contributions for each eligible employee.
Pros and Cons of a SIMPLE IRA
SIMPLE IRA plans come with plenty of benefits for both employees and employers. However, they also come with a few downsides.
Pros of a SIMPLE IRA:
SIMPLE IRA plans have fewer administrative costs, making them more affordable for small businesses.
The paperwork to set up a SIMPLE IRA plan is simple, and the account is effectively created as soon as the form is complete.
Employers are required to contribute to the accounts of all employees, which means employees who contribute are guaranteed an employer contribution.
The money contributed to a SIMPLE IRA plan is tax-deductible for both employers and employees.
Cons of a SIMPLE IRA
The contribution limit for employees in a SIMPLE IRA plan is lower than the maximum contribution for those participating in 401k plans.
For the employer, the contribution requirement can be a disadvantage, since it makes the plan less flexible.
Employers and employees can’t opt for a Roth IRA instead of a traditional IRA for their account, meaning they can’t choose their preferred tax advantage.
Employees can’t roll over their SIMPLE IRA funds into another IRA until they’ve been a plan participant for at least two years.
The Bottom Line
SIMPLE IRA plans present a unique opportunity to both employers and employees. These plans allow small businesses to offer retirement plans to their employees when they otherwise may not be able to. And they allow the employees who work for those small businesses to save $13,500 per year for retirement, in addition to what their employer contributes.
Consider the following steps to help prepare yourself for retirement.
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