What is a SIMPLE IRA?
A SIMPLE IRA is a type of individual retirement account used to help people save for retirement.
The “SIMPLE” stands for Savings Investment Match Plan for Employees.
Like other types of retirement accounts, the SIMPLE IRA is tax-advantaged because it allows account holders to defer taxes on income contributed and capital gains until funds are withdrawn.
What makes this account special is that it is only available to small businesses with fewer than 100 employees or to self-employed individuals.
The SIMPLE IRA also requires employers to contribute to each employee’s account, up to 3% of the employee’s annual salary.
Employers must contribute to the account even if the employee doesn’t contribute to the plan herself.
How SIMPLE IRAs Work
If you work for a company that offers a SIMPLE IRA, you are eligible to participate if you earned at least $5,000 during any part of the two years before the current calendar year and expect to earn at least $5,000 in the current calendar year.
Once you are enrolled, you may contribute pre-tax income to fund the account. Pre-tax income is income that has not been reduced by income taxes. This is an upfront tax break to the account holder; however, income taxes will need to be paid when funds are withdrawn.
The other major tax benefit is that funds in the account can be invested in financial assets, and taxes on capital gains are also deferred until funds are withdrawn.
One feature unique to the SIMPLE IRA: if a company is sponsoring the plan, it must make an additional contribution that either matches the employee’s contributions to the account (up to 3% of the employee’s salary) or is equal to 2% of the employee’s salary.
The employer is required to contribute to the account even if the employee doesn’t.
There are some limitations to the SIMPLE IRA.
There is an annual contribution limit set by the IRS. In 2019, the contribution limit was $13,000, or $16,000 if you are at least 50 years old. This contribution limit doesn’t include the employer match.
The IRS adjusts the contribution limit on an annual basis, so it’s always a good idea to double check with the IRS website.
There are also limitations on withdrawals.
If you make a withdrawal before the age of 59½, a 10 percent tax penalty is applied. If you have participated in the SIMPLE IRA account for less than two years, the 10 percent penalty is increased to 25 percent.
Also, you cannot roll over a SIMPLE IRA into a traditional IRA before the two-year mark. This two-year rule is unique to SIMPLE IRAs.
Finally, if you are age 70½ or older, the IRS requires minimum annual withdrawals from your SIMPLE IRA account.
Comparing SIMPLE IRAs to 401(k)s
The SIMPLE IRA is commonly substituted for a 401(k) plan by small businesses because the SIMPLE IRA is cheaper to set up and administer.
The two account types are similar, but there are some subtle differences. The table below summarizes the key advantages and disadvantages of holding a SIMPLE IRA account versus a 401(k).
Relative to 401(k) accounts, SIMPLE IRA plans are less costly for an employer to set up and administer. Also, the SIMPLE IRA requires employers to match contributions, between 2% and 3% of an employee’s salary, and contributions immediately vest. In the 401(k) account, employer contributions are optional and may take years to vest (case by case).
Another advantage of the SIMPLE IRA is that the employee has more freedom to self-direct investments into stocks or mutual funds of their choice. In a 401(k) account, the employee is presented with a menu of investment options selected by the employer.
The SIMPLE IRA and the 401(k) have similar tax advantages.
On the drawbacks side of the equation, SIMPLE IRAs are only available to small businesses with fewer than 100 employees. The SIMPLE IRA is subject to the “two-year rule,” where accounts held for less than two years face higher withdrawal penalties and rollover limitations.
Finally, a SIMPLE IRA has a lower contribution limit than the 401(k) account, enabling 401(k) holders to stash away more money each year.