What is a SIMPLE IRA?
The Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) is a retirement account specifically designed for small businesses with 100 or fewer employees. It is cheaper and easier to set up as compared to traditional IRA plans. The advantages of SIMPLE IRA plans are that they are easy to establish and are ideal for small businesses with limited budgets and resources at their disposal. They also offer benefits of other retirement accounts, such as tax benefits and rollover credits, at cheap costs. The disadvantage of SIMPLE IRA plans is that they have lower contribution limits in comparison to other retirement plans.
Basics of SIMPLE IRA
SIMPLE IRA plans are ideal for employers who do not have a budget for more expensive retirement plans. Employees who have earned, at least, $5,000 in income from an employer in the previous two calendar years are eligible for inclusion in a SIMPLE IRA.
In this type of IRA, the employer contributions can either be matching (when an employer makes contributions equal to the employee’s) or nonelective (when an employer makes contributions equal to 2% of an employee’s annual compensation). The limit for matching contributions is $13,500 in 2020 and 2021 and that for nonelective contributions is $290,000 for 2021 and $285,000 for 2020. SIMPLE IRA participants who are aged 50 or over can put as much as $16,500 for matching contributions and they can also make catch-up contributions not exceeding $3,000 for 2015-2021.
Like other retirement accounts, you can use the SIMPLE IRA account for trading. Capital gains on trades from within your account are tax-deferred, meaning you don’t pay taxes on gains immediately but may be on the hook for payment during the withdrawal process. Funds in SIMPLE IRA accounts can be withdrawn after 59.5 years of age and they are taxed at the prevailing rate. Premature withdrawals incur 10% penalty plus the prevailing tax rate. Withdrawals in less than two years of setting up an account are subject are to a 25% penalty.
You can also rollover between SIMPLE IRA plans, when you switch employers. The rollovers are tax-free. It is also possible to rollover funds between a SIMPLE IRA account and another retirement account, such as a Roth IRA. However, the transfers are considered tax-free only after you have invested in the SIMPLE IRA plan for a minimum of two years. In a situation when you move jobs and change employers, you may end up making contributions to a 401(k) as well as a SIMPLE IRA. The limit for total contributions to 401(K)s is $19,500 in 2020 and 2021. It is $26,000 if you are 50 or older.
Finally, you can pair up your SIMPLE IRA account with another retirement account, such as a traditional or Roth IRA. The funding limits relevant to both accounts are applicable in this case.
How to Setup a SIMPLE IRA
The process to create a SIMPLE IRA is fairly easy. Small businesses need to fill out Form 5304-SIMPLE (if you want to allow employees to choose the custodian of their account) and Form 5305-SIMPLE (if you plan to choose the account custodian yourself) from the IRS website and distribute it to their employees. The form documents SIMPLE IRA eligibility criteria for the business’s employees and establishes the employer’s contribution percentage for the account. These forms serve as notifications to employees about the account.
The next step is to choose a financial institution that will serve as trustee of the SIMPLE IRA accounts and manage the account. Banks, Savings and Loan institutions, federally-insured credit unions, and brokerages are all examples of financial institutions that are approved for this task.
Advantages and Disadvantages of SIMPLE IRAs
The advantages of SIMPLE IRAs are outlined below:
- SIMPLE IRAs are easy to setup and operate. From an employer’s perspective, they do not require extensive documentation and, after you have selected a financial institution to manage the account, may not require maintenance depending on the nature of assets in your account.
- SIMPLE IRAs are flexible. Employees can rollover between accounts and other retirement accounts. They can change their contribution amounts to the plan during an annual election period that occurs annually or they can even stop making contributions completely to the account.
- SIMPLE IRAs offer several tax benefits to employers and employees. The former can get a tax credit of up to $500 per year for three years for offering SIMPLE IRA to their employees. Contributions made to SIMPLE IRA accounts reduce the overall pre-tax income for employees. This is in contrast to Roth IRAs, which use after-tax income for contributions.
- The tax benefits also extend to trading stocks and bonds from within the IRA account. Hefty capital gains taxes can eat into profits. SIMPLE IRA accounts defer taxes to a later date, when funds are withdrawn from the account or distributions are made. Even then, you will not be paying taxes on increase in investment income. Rather you will be responsible for taxes applicable to distributions made from a retirement account.
- SIMPLE IRA offer immediate ownership of employer matching funds to employees. This is unlike 401(K)s which cannot be withdrawn until after a certain vesting period.
The disadvantages of SIMPLE IRA are as follows:
- SIMPLE IRAs have lower contribution limits as compared to other employer-sponsored retirement accounts. For example, SEP IRAs have contribution limits of up to $58,000. 401(K)s allow a maximum of $19,500 ($26,000, if you are 50 or older) for annual contributions.
- SIMPLE IRAs also have required minimum distributions (RMDs) after a certain age, in order to maintain their tax-free status. This is a disadvantage as compared to Roth IRAs, which allow tax- and penalty-free distributions at any age.