Most people are familiar with retirement savings plans, like a 401(k) or a Roth IRA. But other options are available that provide a way to save for your golden years, especially if you’re self-employed or own a small business. A SIMPLE IRA is just one of these plans. It’s an easy-to-manage retirement account that lets you make tax-deferred contributions. Though, it does have rules and contribution limits you must be aware of.
So, what is a SIMPLE IRA, and is it the right choice for you? Keep reading to learn more about this retirement plan and how it stacks up against other options.
What is a SIMPLE IRA?
SIMPLE IRAs are relatively straightforward to set up and maintain. However, SIMPLE doesn’t refer to how easy it is to use. Instead, it stands for Savings Incentive Match Plan for Employees. Small businesses offer this retirement plan as a benefit to their employees, allowing both employers and employees to make tax-deferred contributions to an employee account.
To qualify for a SIMPLE IRA, a business must have no more than 100 employees and cannot have any other retirement plan in place.
To be eligible as an employee, you must have earned at least $5,000 from the employer during any two years before the current calendar year and expect to make at least $5,000 this year.
An employer can make the requirements to participate easier by lowering the yearly minimum amount set by the IRS. However, employers cannot raise the amount over $5,000 or make access more restrictive by adding additional requirements.
How does a SIMPLE IRA work?
Much like a company-sponsored 401(k), the SIMPLE IRA lets employees choose how much of each paycheck to contribute. Your money grows tax-free until you’re ready to retire, and you pay tax on any money you withdraw after you reach age 59½.
Self-employed individuals can contribute to a SIMPLE IRA as both the employee and employer, which can help them save more for retirement. If you are a freelancer or sole proprietor, a SIMPLE IRA can be beneficial, although other retirement plans may work better by allowing you to contribute more.
If you need to withdraw money from your account early, you must pay a 10% penalty as well as taxes. In addition, the rules of the SIMPLE IRA state that if you withdraw money within the first two years you participate, the penalty increases to 25% plus taxes, which can be a considerable blow to your retirement savings.
What is the SIMPLE IRA contribution limit for 2023?
In 2023, the SIMPLE IRA employee contribution limit is $15,500. If you are older than age 50, the plan allows you to make an additional $3,500 in ‘catch-up’ contributions, or $19,000 total.
Unlike other retirement plans, a SIMPLE IRA requires the employer to contribute to each eligible employee’s account based on rules established by the IRS.
Employers can choose between two contribution options:
- Making up to a 3% match on an employee’s elective deferrals with no annual compensation limit. The employee must contribute to get the employer’s contribution. The employer can lower the matching percentage for up to two years in any five-year period.
- Making a 2% nonelective contribution for each employee. These contributions must be made even if the employee doesn’t put money into the account. Employer contributions must equal 2% of the employee’s compensation up to the annual salary limit of $330,000 in 2023.
An employer must tell you which contribution method they will use for the upcoming year during the annual election period of Nov. 2 to Dec. 31. This time frame is also when employees can adjust their contribution levels for the coming year.
Is a SIMPLE IRA the same as a traditional IRA?
SIMPLE and traditional IRAs have several similarities, but they are different accounts with different rules.
Both are tax-deferred retirement accounts, meaning that any contributions you make during the year help reduce your taxable income. You must also take Required Minimum Distributions (RMDs) beginning at age 73 with both the SIMPLE and traditional IRAs.
Like a traditional IRA, money placed in a SIMPLE IRA can be invested in individual stocks, mutual funds and other investments. However, the investment options may be limited depending on the funds available in the brokerage account. Each employee decides where to invest their money based on the available options.
SIMPLE IRAs differ from traditional IRAs in some essential ways. A traditional IRA has much lower contribution limits (only $6,500 in 2023 or $7,500 if you’re older than 50). Plus, only the individual can contribute to a traditional IRA; there is no employer match. Comparatively, you can contribute significantly more to a SIMPLE IRA in 2023.
In addition, the small business owner must create and maintain the SIMPLE IRA for all their employees. However, both the employer and employee can contribute.
The pros
They require less paperwork to set up. When deciding between a SIMPLE IRA vs. 401(k), business owners may want to consider the administration time each type of account requires. It is generally easier to start and requires less paperwork and ongoing maintenance. Unlike with other plans, employers don’t typically have to file yearly paperwork with the IRS when using a SIMPLE IRA.
They have lower maintenance costs. SIMPLE IRAs generally have lower startup and maintenance costs. Some brokerage firms don’t charge fees to open an account and may waive ongoing fees based on the account balance. Employers can also receive a tax deduction on their contributions to employee accounts.
Contributions are vested immediately. No matter how long they’ve been with the company, the employee owns 100% of the amount in the SIMPLE IRA once the account has been established. This includes any employer matches.
Employees can contribute to other retirement accounts. Employees are eligible to contribute to other retirement plans like a Roth IRA or traditional IRA, even if they have a SIMPLE IRA through an employer.
The cons
They have lower contribution limits than other plans. A SIMPLE IRA allows you to save up to $15,500 a year (or $19,000 for those older 50). However, its contribution limits are still lower than other retirement plans.
For example, the standard 401(k) contribution limit is $22,500 in 2023, plus an additional $7,500 for those older than 50. Other self-employed or small business retirement plans, like a simplified employee pension (SEP) IRA or a Solo 401(k), allow you to save up to $66,000 a year.
SIMPLE IRAs have hefty early withdrawal penalties. The 10% early withdrawal penalty plus taxes is standard on most retirement accounts for any money you take out before age 59½. However, a SIMPLE IRA account charges a 25% penalty if you make an early withdrawal within two years of opening the account.
Loans are not available. SIMPLE IRAs do not allow Participant Loans like some standard 401(k) plans do.
They don’t have Roth options. A SIMPLE IRA cannot be a Roth, meaning you can’t contribute after-tax dollars. This can be a significant drawback since a Roth IRA has a lot of benefits, including tax-free growth and withdrawals in retirement when you meet specific requirements.
Bottom line
A SIMPLE IRA may be a valuable option for small business owners looking for an easy and low-cost way to provide a retirement plan to employees. If you’re self-employed or only have a few employees, this could be a good option compared to other retirement accounts. Just remember: The contribution limits may prevent you from saving as much as you otherwise could.
Be sure to thoroughly research each plan’s pros and cons and speak with a retirement professional to help you make the best decision for you and your business.
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