What is a SIMPLE IRA and How Does It Work?

Are you a small business owner looking to provide your employees with retirement plans? Are you self-employed and don’t have a retirement account but want to get started? A SIMPLE IRA plan makes retirement accounts more accessible for everyone. We will highlight some key details to keep in mind with these accounts and how to get started.

What is a SIMPLE IRA?

A SIMPLE IRA is a retirement account for small business owners and self-employed individuals. Business owners with 100 employees or less can offer these plans to their staff and offer matches for employee contributions. In addition, many people contribute to IRAs for tax advantages.

Contributions to a Traditional IRA are tax-deferred, and you may pay fewer taxes when you distribute funds at retirement age. For example, many people are in a lower tax bracket after they retire, and distributions will be taxed at a lower rate.

You can also opt for a Roth IRA. These retirement account contributions are taxed, but you typically don’t have to worry about taxes on any distributions taken at retirement age, including capital gains and dividends. Roth IRAs are great for investors who experience significant gains on their capital and want to avoid taxes later. However, taxes can catch some IRA holders by surprise.

How Does a SIMPLE IRA Work?

A SIMPLE IRA lets employers create retirement plans for their employees and themselves. Some business owners and gig workers create retirement plans for themselves through the SIMPLE IRA model. These accounts have lower administrative costs than 401(k)s, which makes them attractive choices for small businesses with a modest number of employees. Eligible employees can make salary reduction contributions, and the employer must either make a matching contribution or a nonelective contribution. The IRS sets maximum contribution limits each year and tends to raise them each year based on inflation and other factors.

SIMPLE IRA vs. 401(k)

SIMPLE IRA and 401(k) accounts fulfill the same objective: help employees save money on taxes while growing their portfolios. However, a 401(k) plan has higher salary reduction contribution limits than a SIMPLE IRA plan. 401(k) holders can contribute up to $22,500 in 2023, while SIMPLE IRA investors can contribute up to $15,500 in 2023. Catch-up contributions are also higher for 401(k) plans. Anyone who is 50 years or older can contribute an extra $7,500 per year to their 401(k). SIMPLE IRA investors can still add a respectable $3,500 per year, but the limit remains lower than a 401(k) account. 

Small businesses with 100 employees or less tend to use SIMPLE IRAs because these plans have lower administrative costs. While 401(k) plans have higher contribution limits, the fees can erode profits if administrative fees are spread across a small number of workers. This is one of the reasons small employers and self-employed individuals use SIMPLE IRAs instead of 401(k) retirement plans.

SIMPLE IRA vs. IRA

A SIMPLE IRA plan has a higher contribution limit than an IRA. Investors can only contribute up to $6,500 per year with a traditional IRA or Roth IRA account. This amount jumps up to $7,500 per year for investors who are 50 years or older. IRAs are exclusively for individuals, but SIMPLE IRA plans can cover small business owners and their workers. Some self-employed workers set up SIMPLE IRA plans only for themselves, just like a traditional IRA. Both plans may reduce your taxable income, which effectively lowers your tax bill.

What are the Benefits of a SIMPLE IRA?

A SIMPLE IRA has several advantages for small business owners and employees seeking a quicker path to retirement.

Lower Your Tax Bill

Contributions to a SIMPLE IRA plan may lower your tax bill if you meet certain requirements. At the same time, those funds can go into various assets, such as stocks and mutual funds. A self-directed SIMPLE IRA plan offers additional choices. You can buy alternative assets like crypto and real estate while trimming your taxes.

Higher Maximum Contribution Limit Than Traditional IRAs

The more you contribute to a retirement plan, the more you may save in taxes. The IRS imposes limits to minimize how much people can defer in taxes, but some retirement accounts have higher caps than others. While IRAs limit you to a contribution of $6,500 in 2023 ($7,500 if you are 50 years or older), SIMPLE IRA owners can make salary reduction contributions totaling more than twice as much per year. 

Retain Employees

Small businesses with SIMPLE IRA plans can retain talented workers. Employees look at various factors, such as pay, benefits, and company culture, to shortlist job opportunities. Unsatisfied employees may use these same criteria to leave your company. It costs a lot of money to lose talented workers and train new workers to fill gaps. A good retirement plan like a SIMPLE IRA can make employees feel appreciated and help you keep more of them on your team.

More Affordable than 401(k) Plans

401(k) plans have steep administrative fees, which can be a bit much for a small company. SIMPLE IRAs are more affordable and are optimal for small business owners with a few employees. A retirement account has many advantages, but getting stuck with high 401(k) costs and a small team can minimize returns.

Fulfilling State Mandates

Some states require small business owners to give their workers retirement plans if they fulfill certain criteria. These rules don’t just extend to large corporations. Each state has different rules, but if you just meet the criteria with a few employees, it’s better to seek out a more affordable retirement plan. 

What are the Risks of a SIMPLE IRA?

While SIMPLE IRAs can accelerate your path to retirement, they’re not the only game in town. Understanding the risks of SIMPLE IRAs will help you consider other retirement accounts and ways to allocate your capital.

The Employer Must Make Contributions

While this requirement helps workers, it can be to the detriment of small business owners operating on limited budgets. Employers must provide a dollar-for-dollar match of up to 3% of an employee’s salary deferral contributions or contribute 2% of the employee’s total salary, up to certain limits, to their plan. 401(k) plans do not require employers to match employee contributions, but most do this anyway. It’s not a large expense for most companies, but small business owners locked into this commitment may experience financial stress if operating with tight margins.

Employees May Prefer 401(k) Plans

401(k) plans have higher contribution limits than SIMPLE IRA plans. Employees may work for your company (or seek opportunities in the future) when a compelling retirement plan is offered.

No Roth IRA Component

SIMPLE IRAs currently do not have a Roth component. Therefore, if you want to be taxed on your income now and avoid capital gains and dividend payments in the future, you will need a different type of individual retirement account. 

Taxes Await on the Other Side

When you distribute funds from your SIMPLE IRA, you will have to pay taxes on those proceeds. The money is taxed based on your income tax bracket. While this number may be lower when you retire, tax payments can catch people by surprise, especially with social security income propping up your taxable income.

Be Mindful of Fees

SIMPLE IRAs have lower fees than 401(k) accounts, but it’s still important to keep them in mind. Every expense reduces your profits, and you still owe taxes on the cash sitting in your account. 

You Shouldn’t Rush to Distribute Funds or Rollover Your Account

SIMPLE IRAs have stiff penalties for early distributions. If you withdraw funds or roll them into a new IRA too early, you may have to pay taxes and penalties. That doesn’t even include income taxes. If you plan to roll over a SIMPLE IRA, make sure you haven’t touched it for at least two years. Most IRAs are more generous, and it’s rare to find an IRA that charges fees for a rollover.

Other SIMPLE IRA Considerations

We have assessed the pros and cons of SIMPLE IRAs, but this doesn’t paint the entire picture. Keep the following considerations in mind when reviewing SIMPLE IRA plans and determining if it’s the right approach for you.

Contribution Limits

Employees can make salary reduction contributions of up to $15,500 to their SIMPLE IRA in 2023. SIMPLE IRA account holders who are 50 years or older can contribute an additional $3,500 in 2023. 

SIMPLE IRA Rules

SIMPLE IRAs have more rules than most retirement accounts. Employers must make contributions, and there are stiff penalties for early withdrawals and rollovers. 

Qualified Assets

A conventional SIMPLE IRA only allows public market assets, such as stocks, mutual funds, and bonds. A self-directed SIMPLE IRA plan provides you with more choices, such as real estate, crypto, and precious metals.

Notice and Filing Requirements

If you start a SIMPLE IRA, you must provide annual notices to your employees before November 2nd. This notice provides a summary plan and allows employees and employers to modify the SIMPLE IRA plan. Employers can decide how they match contributions, and employees decide on the custodian, the impact on their salary, and other details. 

Termination

Employers cannot terminate SIMPLE IRA plans in the middle of the year. They must wait until the end of the year to end the program and must notify employees in advance. If you do not notify your staff by November 2nd, you may have to keep the SIMPLE IRA program in effect for the following year as well.

Is a SIMPLE IRA Right for You?

A SIMPLE IRA can be a great fit for small business owners and self-employed workers who want to save for retirement. These accounts let you defer your taxes, so you don’t pay additional taxes when you find yourself in a higher income bracket. Withdrawing funds when you retire and no longer have a salary means you keep more of your wealth.