How a SIMPLE IRA works

The 401(k) has long been the go-to retirement vehicle for U.S. employers. For small businesses, however, these savings plans can be expensive and cumbersome to operate. That's why many smaller organizations offer workers a more streamlined choice: a Savings Incentive Match Plan for Employees individual retirement account (SIMPLE IRA).

So what is a SIMPLE IRA, exactly, and how does a SIMPLE IRA work? Here's an overview of this alternative retirement benefit, along with some pros and cons for both employers and employees to consider.

A SIMPLE IRA offers a flexible, convenient way for a business owner to contribute to both their own and employees' retirement savings. You decide the contribution amount that you'd like to be automatically deducted from your paycheck into the SIMPLE IRA. Plan contributors will be able to choose the investments for the contributions made into the SIMPLE IRA. Contributions made to the plan are "taxed later," meaning they are tax-deferred so your tax liability will come once you withdraw funds down the road.

SIMPLE IRAs are a great way to save for retirement and experience the effect of compound interest.

> Learn more about how compound interest works: Investing compounding & how it affects your returns

Any small business with a maximum of 100 employees can establish a SIMPLE IRA, as long as the business doesn't offer any other retirement plan. You make certain matching or non-elective contributions directly to each eligible employee's SIMPLE IRA, including your own.

You must contribute to your employees' plans in one of two ways:

• Make a matching contribution of up to 3% of the employee's wages. Note that the 3% match can be reduced anywhere down to 1% in two years out of a five-year period.

• Make a nonelective contribution equal to 2% of wages (up to the annual wage limit of $330,000 for 2023 or $345,000 for 2024) for employees who don't fund their own accounts.
  

More common employer-sponsored retirement plans, like 401(k)s, tend to have considerable setup and operating costs, whereas SIMPLE IRAs come with fewer regulations. For example, they don't require an annual filing, and there's no rule about completing discrimination testing to demonstrate that benefits aren't too heavily weighted toward top earners. They usually cost less to administer as well. You will want to review your plan annually to ensure it's operating in compliance with IRS rules and regulations.

Establishing a SIMPLE IRA for your business may allow you to claim the Retirement Plan Startup Costs Tax Credit. This credit is designed to help offset startup costs for small businesses that set up retirement plans for their employees, and it's worth up to $5,000 per year for three years.

The Secure Act 2.0 changed some contribution requirements for SIMPLE IRAs. Small employers can make additional employer contributions (beyond the current required match/nonelective) up to the lesser of $5,000 or 10% of compensation (inflation-adjusted).

Today, employers with under 100 employees may be eligible for a three-year start-up tax credit of up to 50% of administrative costs, up to $5,000 annually. SECURE 2.0 increased the employer tax credit to 100% of qualified start-up costs for employers with 50 employees or fewer. What's more, a credit of up to $1,000 per employee for eligible employer contributions may apply to employers with up to 50 employees (but phases out from 51-100 employees).

• For employers with 25 or fewer employees, the deferral and catch-up contributions will be increased by 10%.
  
• For employers with 26-100 employees, you are eligible to make larger contributions for your employees if you increase your employer match to 4%, or the nonelective contribution to 3%.

Because of the lower costs and regulatory requirements, SIMPLE IRAs are a compelling option for many small businesses. These tax-advantaged plans can be a powerful savings tool for employees trying to build financial assets for retirement. Still, it's important to understand that these plans have certain drawbacks compared to 401(k)-style plans.

• SIMPLE IRAs are generally cheaper and less time-consuming to administer than 401(k)s.
• Contributions are tax-deductible for the employer, within legal limits.
• Employers don't have an annual filing requirement.
• Employers don't have to perform discrimination testing.

• Loans from the plan aren't permitted.
• Employer contribution rules are more rigid than other plans.
• Contribution limits are less than 401(k)-style plans.
• A Roth option may not be available immediately. Historically, Roth SIMPLE IRAs were not available at all, but the Secure Act 2.0 now allows them.
• Early withdrawal penalty is 25% for plan participants in the first two years.

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SEP vs SIMPLE IRA: Is one right for you?

Simplified Employee Pension (SEP) and Savings Incentive Match Plan for Employees (SIMPLE) individual retirement accounts (IRAs) are two of the most popular and convenient ways for a business owner to contribute to both their own and employees' retirement savings. But how do you choose between them?

Compare options

Setting up a SIMPLE IRA is a fairly simple process. That makes them popular among startups and other small businesses that don't have the financial resources or personnel to manage more complicated plans.

You can create a SIMPLE IRA for your business in three steps. Consult with your tax advisor and financial advisor to confirm your eligibility for plan adoption.

Use Form 5304-SIMPLE if you allow individual employees to choose their financial institution. Keep a copy for your records and make copies for all eligible employees and your financial advisor. Do not file this form with the IRS. Consult with your tax advisor to confirm your eligibility for plan adoption

Provide a copy of the 5304-SIMPLE that provides plan information and clarifies the participant's ability to make or change their contributions. It also must notify them of your choice to make either matching or nonelective contributions.

Obtain from your employees the location (financial services provider) and account number of their SIMPLE IRA.

Your financial advisor can help with both pieces of this step.

Make necessary modifications to begin withholding salary deferral contributions from employees' paychecks and send them directly to your employees' respective SIMPLE IRAs. The chosen financial institution acts as a trustee, accepting contributions to the plan and holding any plan assets. It also determines the investment choices available to plan participants. If you prefer, you can let your employees choose the financial institution that accepts their contributions.

If you work for a small business that offers a SIMPLE IRA, you're allowed to participate as long as you earned at least $5,000 each of the past two calendar years and expect to earn at least $5,000 in the current year as well (though your employer may choose to make these requirements less restrictive). You can contribute to the account at the financial institution of your choice, depending on how the plan is set up.

• 2023 contribution limit for those under age 50: $15,500
• 2023 contribution limit for those age 50 or older: $19,000

• 2024 contribution limit for those under age 50: $16,000
• 2024 contribution limit for those age 50 or older: $19,500

Participating in a SIMPLE IRA can be a great way to maximize your retirement savings for several key reasons.

• Tax advantages. You make contributions through payroll deductions on a pretax basis, and your assets grow on a tax-deferred basis. Consequently, you may not have to pay any tax until you make withdrawals after age 59½—at that point, anything you take out is subject to your ordinary income tax rate.

• Employer contributions are mandatory with these plans. Many employers opt to match employee contributions, up to 3% of their wages. Alternatively, your place of work may decide to make a contribution equal to 2% of your salary, whether you make your own contributions or not. Either way, your retirement savings will get an extra boost.

• You're 100% vested in these employer contributions from the first day of your participation. That means you fully own them, no matter when you leave the company. With 401(k) plans, you may have to wait several years before you're fully vested in the employer portion of your account.

All that said, a SIMPLE IRA has some possible downsides for participants compared to more common workplace plans.

• May not have a Roth version available immediately, since the Secure Act 2.0 just allowed for this option in late December 2022.
• You can't take loans from the plan, a feature many 401(k) sponsors offer.
• You're also subject to lower contribution limits when compared to a 401(k), with a limit of $15,500 in 2023 or $16,000 in 2024 (those 50 or older can contribute an additional $3,500). 401(k) limits for 2023 are $22,500 or for 2024 are $23,000 for those under age 50 (with an additional $7,500 permitted for a catch-up contribution).

As with other tax-advantaged retirement plans, the tax code heavily encourages participants to keep money in their account until age 59½. As with traditional 401(k) plans, withdrawals from your SIMPLE IRA before that age are typically subject to a 10% early withdrawal penalty, plus income taxes. But with SIMPLE IRAs, that penalty shoots up to 25% if you make an early withdrawal within the first two years of participating in the plan.

What happens to your money if you move on from your employer for any reason? As with most retirement plans, you simply can leave your assets in the plan and make withdrawals after age 59½. However, you also can roll the employer plan into a SIMPLE IRA after two years without any immediate tax consequences.

Additionally, you have the option to roll the funds into a regular IRA or an employer-sponsored retirement plan, tax- and penalty-free, as long as you've participated in the plan for at least two years.*

A financial advisor in your area can help both employers and employers figure out how to maximize contributions and build a comprehensive plan that meets both your near-term and retirement goals. Connect with someone local today.