How SIMPLE IRA Plans Work: A Comprehensive Guide for Employers and Employees

A SIMPLE IRA is a retirement savings plan designed for businesses with 100 or fewer employees. It’s called “SIMPLE” because it stands for “Savings Incentive Match Plan for Employees.” This plan can be a budget-friendly option for small business owners who want to provide their employees with a retirement savings plan, without the high costs or possible restrictions of a 401(k) plan.

How a SIMPLE IRA works

In simple terms, a SIMPLE IRA is quite similar to a traditional IRA. It mostly follows the same rules when it comes to how you can invest your money, when you can take it out, and how you can move it around.

However, the way you put money into a SIMPLE IRA is more like how you contribute to a 401(k) plan. There are two parts to funding a SIMPLE IRA: money that you choose to set aside from your paycheck (that’s the elective salary deferral part), and money that your employer contributes on your behalf (that’s the nonelective contribution).

The employer’s contribution can be one of two things:

• A fixed 2% of your salary. But, there’s a limit on how much of your salary they consider when calculating this, which was $305,000 in 2022 and $330,000 in 2023.

• Matching contributions, where your employer adds up to 3% of your salary to your account, and there’s no limit on your salary they use for this calculation. (Though, sometimes they can temporarily lower the match rate under certain conditions.)

So, a SIMPLE IRA gives employees some of the benefits of a 401(k) plan, but it’s wrapped up in the simpler and usually cheaper package of an IRA. Setting up and managing 401(k) plans can be expensive and a bit of a hassle, whereas SIMPLE IRAs are typically easier to handle.

SIMPLE IRA vs. Traditional IRA

SIMPLE IRAs share a few similarities with traditional IRAs. Your contributions to both types are tax-deferred, which means the money you save, up to the contribution limit, reduces the amount of your income that gets taxed for the year. Additionally, any investment growth isn’t taxed until you start withdrawing the money after you reach 59 ½ years old.

SIMPLE IRA vs. 401(k)

In some ways, SIMPLE IRAs resemble 401(k) plans: Eligible employees specify how much of their paycheck they want to put into the account, if they choose to contribute anything, and that money is automatically funneled into their individual investment account. However, the major difference lies in how much employees can actually contribute.

Advantages and Disadvantages of SIMPLE IRA

Advantages of a SIMPLE IRA:

1. Cost-Efficient: It’s typically cheaper to get a SIMPLE IRA up and running and keep it going compared to a 401(k) plan.
2. Investment Flexibility: You usually have the freedom to invest in a wide range of stocks and financial options within your SIMPLE IRA, with only a few restrictions on really risky stock choices.
3. Immediate Ownership: When your employer contributes to your SIMPLE IRA, you own that money right away; you don’t have to wait for it to become fully yours.

Drawbacks of a SIMPLE IRA:

1. Lower Contribution Limits: The amount you can set aside from your salary and the maximum percentage your employer can match are usually less than what you’d find in a 401(k) plan.
2. No Roth Choice: In a SIMPLE IRA, the money you put in from your paycheck is always treated as tax-deferred, and it’s mixed together with what your employer adds.
3. Penalty for Quick Rollovers and Withdrawals: If you move your money around or take it out within two years of starting your account, there’s an additional penalty you might have to deal with.

SIMPLE IRA rules and contribution limits

There are two main types of contributions you can make to a SIMPLE IRA: ones you choose to put in as an employee and ones your employer adds in for you.

In 2022, the most you can personally put into your SIMPLE IRA is either 100% of your salary or $14,000, whichever is lower. But in 2023, that limit goes up to $15,500. If you’re 50 years old or older, you can toss in an extra $3,000 in 2022, or $3,500 in 2023. These contributions come right out of your paycheck, so they’re not counted as income for tax purposes. However, they do have to deal with FICA and unemployment taxes.

Here’s a cool thing: putting money in your SIMPLE IRA doesn’t mean you can’t stash cash in other retirement plans provided by your employer, if they offer any. You can also open your very own traditional IRA and put money in there too. However, if you’re into a fancy move called a “backdoor Roth IRA,” having a SIMPLE IRA might complicate things a bit.

Is a SIMPLE IRA the right choice for you?

Well, it really depends on whether you’re an employee or an employer.

For Business Owners: If you’re a solo business owner or self-employed and you’re looking to supercharge your retirement savings, there are other retirement plans that let you put away even more money:

• A solo 401(k) allows business owners with no employees to stash up to $66,000 in 2023, and if you’re 50 or older, you can add an extra $7,500 as a catch-up contribution. There’s one exception: If your spouse earns income from your business, they can be included.
• Then there’s the SEP IRA (Simplified Employee Pension Individual Retirement Account), which is somewhat like a SIMPLE IRA. But, just like the solo 401(k), it lets you contribute a lot more: either 25% of your compensation or up to $66,000 in 2023.

Now, if you run a small business with employees and you want to provide them with a retirement plan without dealing with the extra administrative hassles of a 401(k), a SIMPLE IRA could be appealing. But keep in mind that some of your employees might prefer a 401(k) because it allows for higher contribution limits.

For Employees: If you have access to the SIMPLE IRA plan at your workplace and you’re eager to maximize your savings, participating in it might be a smart move to grab some free money.

If your plan includes an automatic 2% employer contribution, you’ll receive that money even if you choose not to put any of your salary into the plan. However, if your employer’s contribution is based on matching funds, you’ll need to sign up to contribute a portion of your salary to get that match. (And remember, you can still save in other types of retirement accounts alongside your SIMPLE IRA.)

How to set up a SIMPLE IRA

Employers can get a SIMPLE IRA plan in a couple of ways: they can follow one of the sample plans provided by the IRS, or they can use a pre-made plan offered by their chosen brokerage. After that, they need to give all eligible employees the lowdown on the plan and tell them where their contributions will go. Lastly, they create a SIMPLE IRA for each employee and complete either form 5305-S or 5305-SA, depending on whether they’re setting up a trust or custodial account. Many online brokerages can take care of these steps for you.

Now, if you want to set up a SIMPLE IRA for the current tax year, you usually need to get it done by October 1st. But if you’re a brand-new employer starting up after October 1st, you can still get your SIMPLE IRA going as soon as you can, according to IRS rules.