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What Is A Simple IRA And How Does It Work

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 9 minute read

Due to the high expenses and potential difficulties, small businesses typically do not provide 401(k) plans to their employees. If this continues, what options do workers and business owners with small companies have for retirement security?

The Savings Incentive Match Plan for Employees or SIMPLE IRA, to shorten it is a form of employer-sponsored retirement plan designed especially for workers at small firms. Here’s the lowdown on what you ought to know.

How Do SIMPLE IRAs Work?

SIMPLE IRAs, like traditional IRAs and 401(k)s, allow you to save and invest for retirement without having to pay taxes on the earnings you make. All employee contributions are deducted before taxes are calculated. 

Basically, you won’t have to pay taxes on any of the money you use to fund your SIMPLE IRA. Additionally, the Internal Revenue Service places annual contribution limits on SIMPLE IRAs, just as they do on IRAs and 401(k)s. Despite the name, a SIMPLE IRA is more similar to a 401(k) than a conventional IRA.

What Sets SIMPLE IRAs Apart From Other IRAs

The employee is responsible for opening and managing the IRA account from the beginning. In every aspect, the account belongs to the worker. SIMPLE IRAs, on the other hand, are sponsored by employers and are normally established and managed by the company itself. 

Employees’ SIMPLE IRA funds are often held by a brokerage the company selects, like Schwab or Vanguard. However, the employer is under no obligation to provide assistance with the setup or maintenance of employees’ SIMPLE IRAs if they so choose.

SIMPLE IRAs also outdo regular and Roth IRAs when it comes to contribution caps. A taxpayer under the age of 50 can contribute up to $13,500 to a SIMPLE IRA in 2021; those beyond the age of 50 can contribute an additional $3,000 as a catch-up contribution, for a total of $16,500. 

If you’re over the age of 50, you can contribute an additional $1,000 to your regular or Roth IRA, bringing the total contribution to $6,000. While Roth IRAs are an option, SIMPLE IRAs do not. What this means is that you can’t choose to pay taxes now on the contributions and then take the gains tax-free in retirement.

Investing in an IRA and a SIMPLE IRA

Brokers like TD Ameritrade make it possible for taxpayers with lower incomes to invest in retirement plans like the regular IRA, Roth IRA, and SIMPLE IRA. Combining a SIMPLE IRA with a regular or Roth IRA is subject to the same contribution limits imposed by the Internal Revenue Service as is the case with a 401(k). 

Your eligibility to make contributions to both an individual retirement account (IRA) and an employer-sponsored retirement plan begins to phase out after your income reaches a particular amount for details, see IRS deduction limits.

What Sets SIMPLE IRAs Apart From 401(k)s

Employer-sponsored SIMPLE IRA plans offer small firms with 100 or fewer workers a more affordable and adaptable retirement savings option than traditional 401(k)s. Employers provide matching funds, but without the hassle and expense of 401(k) administration.

Like 401(k)s, SIMPLE IRAs have a limit on the percentage of salary that can be contributed by the employer. After an employee’s annual salary reaches $280,000, the employer’s duty to make a contribution stops.

In contrast to 401(k) plans, however, SIMPLE IRAs have higher limits on employee contributions. Employees under the age of 50 can contribute up to $19,500 a year to their 401(k) plans, while those over the age of 50 can put in up to $26,000.

Not only are there other distinctions, but those already mentioned are only the beginning.

1. The Need for Contribution

With a 401(k), companies are not required to make any financial contributions to their employees’ retirement plans. SIMPLE IRAs are an exception to this. 

Employers must provide one of two employee contribution programs for these accounts, as required by law:

  • A nonelective contribution equaling 2% of the employee’s salary, no strings attached.
  • A matching contribution of up to 3% of the employee’s salary. If the employee doesn’t contribute, the employer doesn’t contribute.

In the second case, the company may choose to contribute only 1% of the employee’s annual salary for up to two years out of every five. Who’s a helpful disclaimer for young businesses that are strapped for cash?

Employees who have made at least $5,000 in each of the preceding two years and who have a reasonable expectation of making at least $5,000 this year are subject to the contribution obligation. Employers often need the bare minimum of two years of employment for a 401(k) account, while the legal minimum is only one. 

Part-time workers with earnings of $5,000 or more are entitled to SIMPLE IRAs, meaning that employers must provide this benefit regardless of whether they work full-time or not.

There are two other exemptions: employees who get benefits under a collective bargaining agreement, and nonresident immigrant employees who did not earn any money in the United States.

3. Rollover Limitations

Employees can only transfer their SIMPLE IRA funds to another retirement plan such as a standard IRA or 401(k) after they have contributed to their SIMPLE IRA for at least two years. A participant can only transfer their balance to another SIMPLE IRA if they have participated for less than two years before changing jobs.

The situation becomes more complicated for workers whose new employer doesn’t provide a SIMPLE IRA. One of the most common pitfalls in retirement preparation is overlooking retirement benefits from previous companies.

There is no Roth option for SIMPLE IRA accounts, but once two years have passed since the first contribution, employees are allowed to roll over the money to another type of retirement plan.

Learning how to roll over assets from a SIMPLE IRA is important if you are seeking to do so following a job change.

3. More Investment Flexibility

In a 401(k) plan, employees are limited to the investment vehicles approved by the plan administrator. Workers, on the other hand, have more freedom to select their own investments (stocks, bonds, mutual funds, ETFs, etc.) when they set up their SIMPLE IRAs through a brokerage. 

Employees typically have a lot of freedom of choice when it comes to investing at brokerages. Target-date funds allow workers to invest at any time without having to worry about rebalancing their portfolios as retirement approaches.

4. Better and less expensive for employers and employees.

It is possible for businesses to set up 401(k) accounts with brokerage firms rather than hiring a separate administrator. This means they won’t have to pay anything to get started, and in some situations, they won’t even have to pay for maintenance. 

Charles Schwab, for instance, does not impose any maintenance or yearly fees on SIMPLE IRAs. When compared to the exorbitant costs of 401(k) plans, which can hit both companies and workers hard, this is a huge plus.

One potential downside deserves consideration, though. Employers, if they choose to shoulder the burden of opening the accounts, must create a unique account for each employee, unlike with a 401(k).

The company may choose to have workers form their own SIMPLE IRAs. When this is the case, all employers need to do is deposit money into the accounts during each pay period.

5. Increased Fines for Withdrawals Made Early

The Internal Revenue Service frowns upon anyone who cashes in their retirement funds before the age of 59 1/2. Then, it hits you with a 10% penalty on top of the regular income taxes owed on the money you took out.

That is true for all types of retirement accounts, including traditional IRAs, Roth IRAs, SIMPLE IRAs, and the aforementioned 401(k)s and 403(b)s.

To be sure, SIMPLE IRAs have much to offer. The 10% penalty for withdrawing from your SIMPLE IRA before age 59 1/2 increases to a 25% penalty if the withdrawal is made within the first two years of your plan participation. There are a few situations where this fine won’t apply. 

That won’t happen if:

  • You incur non-reimbursed medical expenses and use the withdrawal to cover them.
  • You receive the SIMPLE IRA account from someone who died.

6. Restriction of Business Size

SIMPLE IRAs, in contrast to 401(k)s, are designed specifically for companies with fewer than 100 employees. To qualify as a small business and provide a SIMPLE IRA, a company must have 100 or fewer employees and pay at least $5,000 in employee compensation or compensation for dependents in a given year. 

It is not necessary to include independent contractors or employees earning less than $5,000 per year in the calculation. A 1099 worker is not included in the total employee count either.

Equally, unlike part-time workers, small business owners are under no obligation to provide independent contractors with SIMPLE IRA contribution benefits.

7. Loans Not Accepted

While many 401(k) plans do indeed let employees take loans against their savings, Simplified Employee Pension Individual Retirement Accounts (SIMPLE IRAs) do not.

That’s a trait both types of IRAs have in common. If you need cash quickly, don’t expect to be able to withdraw it from your SIMPLE IRA without paying a penalty.

Choosing between a SEP IRA and a SIMPLE IRA

A SEP IRA might be the best option for freelancers and organizations with a limited number of workers. This is due to the enormous $58,000 annual contribution limit for SEP IRAs.

SEP IRA contribution limits are more than twice the SIMPLE IRA limits, which are $13,500 on the employee side and an additional $13,500 on the employer profit-sharing side for self-employed workers.

In contrast to SIMPLE IRAs, SEP IRAs permit contributions from prior years. Your tax preparer or a financial counselor should be consulted before settling on a SEP IRA or a SIMPLE IRA.

How to Set Up a Simplified Employee Pension in 5 Simple Steps

Interested in moving forward with a SIMPLE IRA retirement savings plan for your small business? Here are five quick steps to follow

Step 1: See If You’re Qualified

If your company has less than 100 employees who each make $5,000 or more annually, you are eligible. That’s how easy it is.

Step 2: Pick a Provider

Pick a broker that gives you the option of opening a SIMPLE IRA. Some of the most well-known brokerage houses are TD Ameritrade, T. Rowe Price, Fidelity, Vanguard, Charles Schwab, Edward Jones, and the rest.

Prior to signing anything, be sure you fully grasp the pricing schedule. Vanguard, for instance, levies a $25 annual fee per account but waives it for those with particularly large balances. As was previously stated, SIMPLE IRAs at Schwab incur no ongoing service charges.

Step 3: Fill out the IRS forms.

If the Internal Revenue Service didn’t require you to file paperwork, it wouldn’t be the IRS. Aside from the paperwork required by your brokerage firm, you must also furnish your staff with a separate form.

The person who will be opening the SIMPLE IRA accounts will determine which form is necessary.

  • IRS Form 5305-SIMPLE. If you open SIMPLE IRA accounts with the brokerage yourself on your employees’ behalf, use this form.
  • IRS Form 5304-SIMPLE. If you have your employees open their own SIMPLE IRA accounts with the brokerage of their choice, use this form.

Although this document is not required to be filed with the IRS, businesses are advised to keep copies on hand just in case.

Step 4: Register Your Employees

You can expect assistance with employee enrollment from your plan provider. They supply the links for signing up and enrolling, which is often done online.

It’s important to remember that the first three quarters of the year are the only ones in which a company can establish a SIMPLE IRA for their employees. If a business wants to establish a SIMPLE IRA after October 1st, it will have to do so the following calendar year.

Step 5: Organize contribution payments

It is easy to set up payroll direct deposits so that all eligible employees receive their wages automatically. Never forget that deductions for contributions must precede those for payroll taxes. Without this, the goal itself would be rendered useless.

Bottom Line

A SIMPLE IRA is a low-cost and low-hassle alternative to a 401(k) plan that small firms can offer to their employees. Employers will only have to pay for the contributions themselves, as there are no initial or ongoing costs.

However, SIMPLE IRAs are subject to their own set of regulations and guidelines; you should familiarize yourself with these details before making any promises to employees.

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