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What is a SIMPLE IRA Plan and How Does it Work?

older employee deciding to use a simple ira plan

For small-business employers contemplating offering a retirement plan, it is prudent to consider the benefits of establishing a SIMPLE IRA plan. In particular, there are numerous perks to employers and their workers as compared to more complex and rules-heavy retirement plans . To help employers as they research and compare retirement plans for their business, here are some key factors of these plans, including:

  1. Plan definition
  2. How does a plan work?
  3. Pros and cons
  4. Setting up a plan

What is a SIMPLE IRA?

A Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) IRA plan is an easy-to-manage savings plan that lets participants save for retirement with tax-deferred dollars. Contributions in this plan get invested in a similar manner to traditional Individual Retirement Arrangements (IRAs), where individuals contribute to their plan with pre-tax dollars and investments can grow tax-deferred until they are withdrawn.

A SIMPLE IRA is built for smaller employers, since this plan allows them to avoid more complex structure and regulations that are found with traditional retirement plans, while still offering a sought-after benefit to their employees.

Key attributes of a SIMPLE IRA:

  • Available to employers with 100 employees or less
  • Employers are required to make contributions to individual accounts set up for each eligible employee.
  • Employees may defer a part of their salaries into the plan for retirement.
  • Employers and employees can both make contributions.
  • Employer contributions are always 100 percent vested.

Is a SIMPLE IRA the same as a traditional IRA?

There are similarities between a SIMPLE IRA and a traditional IRA. For instance, a SIMPLE IRA follows the same investment, distribution, and rollover rules as traditional IRAs. However, key differences include contribution limits for each plan and who can open an account. See the table below to compare SIMPLE IRA vs. traditional IRAs.

 

SIMPLE IRA

Traditional IRA

Plan description

Set up by employer on behalf of the employee; can also be set up by self-employed individuals and sole proprietors

Set up by an individual saver/investor toward their retirement savings

Plan eligibility

Employer has 100 employees or less who earned at least $5,000 in the previous year

Individual that earned income in the past year

Who contributes to the account?

Employer and employee

Account owner

Participant contribution limits (2021)

Up to $13,500 per year (plus additional $3,000 catch-up contribution for employees 50+)

$6,000 (for total annual contributions to traditional and Roth IRAs combined)

Employer match

Employer must either make a non-elective contribution of at least 2 percent of compensation for all eligible employees earning at least $5,000, OR

make a matching contribution of 100 percent up to the first 3 percent of compensation

None

Tax-deductible contributions

Yes

Yes

How does a SIMPLE IRA work?

With a SIMPLE IRA, you and your employees can put a percentage of pay aside for retirement, up to the contribution limit. The money grows tax-deferred until it's withdrawn. Employees don't pay taxes on investment growth, but they will pay income taxes when making withdrawals.

SIMPLE IRA rules: Contributions and limits

Keep in mind the following rules around contribution limits for employees and employers in tax year 2021:

Employee contribution limits

For a SIMPLE IRA in 2021, an employee under age 50 can contribute up to $13,500. People age 50 and older can make an additional $3,000 catch-up contribution, for a total of $16,500.

Employer contribution limits

An employer is required to make a contribution to a SIMPLE IRA plan and can choose either of the following options:

  • Make a non-elective contribution of at least 2 percent of compensation for all eligible employees earning at least $5,000. Maximum compensation is $290,000 for the 2021 tax year.
  • Make a matching contribution of 100 percent up to the first 3 percent of compensation.

SIMPLE IRA rules: Withdrawals and transfers

Employees who make early withdrawals from their SIMPLE IRA will generally incur significant penalties. In general, SIMPLE IRA distribution rules mirror traditional IRA rules, except for non-qualified withdrawals within the first two years of participation. If an employee has had the SIMPLE IRA for less than two years and withdraws money before age 59½, they will be subject to both the standard 10 percent penalty from the IRS, as well as an extra 15 percent early withdrawal penalty — totaling 25 percent of the money taken out going toward penalties owed to the IRS, plus any applicable income taxes. For a $10,000 early withdrawal, that means a minimum $2,500 will go toward a tax bill.

There are also stringent rules around transfers and rollovers to another IRA or employer-sponsored retirement plan. Balances rolled over from the plan into anything other than another SIMPLE IRA during the two-year period after first participating in the plan are taxable.

Pros and cons of SIMPLE IRA plans

When considering a SIMPLE IRA, it's important to understand the advantages and drawbacks of this type of plan. Some notable benefits of establishing a SIMPLE IRA plan for employees include:

  • Like other types of employer-sponsored retirement plans, SIMPLE IRAs allow employee participants to defer part of their salaries on a tax-deferred basis. Contributions can be made through payroll deductions.
  • SIMPLE IRA plans are relatively straightforward to establish.
  • Employees are immediately 100 percent vested in all SIMPLE IRA contributions. As opposed to the majority of qualified plans, matching employer contributions immediately belong to employees and travel with them if they leave employment.
  • Businesses may be eligible to receive a tax credit of up to $5000 per year (for the first three years from the plan's inception) to help offset setup and administrative costs of establishing the plan.
  • Employers do not have to file Form 5500 as part of the plan's requirements.

There are also some disadvantages of setting up a SIMPLE IRA, some of which include:

  • Contribution limits for SIMPLE IRA plans are lower than other workplace retirement plans, such as a 401(k) plan. In 2021, employees, sole proprietors, and self-employed workers under age 50 can contribute $13,500 to a SIMPLE IRA, versus $19,500 to a 401(k).
  • Businesses are required to match employee contributions up to a certain percentage. Compare this to a retirement plan such as a 401(k), where employer contributions aren't required.
  • Employers must follow strict rules set by the IRS, including rules around withdrawals and transfers (see SIMPLE IRA rules section above).

Setting up a SIMPLE IRA plan

SIMPLE IRAs are known for their ease of plan setup. You may be able to set up your plan in just a few steps, as outlined by the IRS:

  • Execute a written agreement to provide benefits to all eligible employees using Form 5304-SIMPLE or Form 5305-SIMPLE, which are model SIMPLE plan documents.
  • Give employees certain information about the agreement, including an annual notice to eligible employees.
  • Set up an IRA account for each employee at an authorized financial institution.

After the SIMPLE IRA is set up, you and your employees can choose to make regular pre-tax contributions through payroll deduction. You can also choose how money gets invested.

Both candidates and current employees value workplaces that offer some type of retirement plan — and the more attractive, the better. That's why offering a SIMPLE IRA plan is an effective way to attract future employees, retain the workforce you currently have, and enjoy the benefits of an easy-to-manage plan.

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* This content is for educational purposes only, is not intended to provide specific legal advice, and should not be used as a substitute for the legal advice of a qualified attorney or other professional. The information may not reflect the most current legal developments, may be changed without notice and is not guaranteed to be complete, correct, or up-to-date.

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