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The Small Business Guide to Simple IRAs

Max Freedman
Max Freedman

SIMPLE IRAs are employee retirement accounts especially useful for small businesses new to offering retirement benefits.

In September 2020, a survey found that approximately 1 in every 3 employees wanted their employer to offer retirement benefits. If this fact compels you to offer retirement plans for your employees, then a SIMPLE (Savings Incentive Match PLan for Employees) individual retirement account (IRA) is a great place to start. Below, learn how SIMPLE IRAs work and why they're especially useful for small businesses new to offering retirement benefits.

 

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What is a SIMPLE IRA?

A SIMPLE IRA is a retirement plan through which employees and employers can contribute to employees' retirement accounts. You might benefit from a SIMPLE IRA if your small business isn't currently sponsoring employee retirement plans but you're eager to do so. That's because SIMPLE IRAs are easy to start and nearly as comprehensive as more complex types of retirement accounts.

How does a SIMPLE IRA work?

You should keep these rules and considerations in mind when starting and administering a SIMPLE IRA for your business.

Business size

Any business with 100 employees at most can establish a SIMPLE IRA. However, for especially small businesses – those with just a few employees – a SEP IRA may be easier to start and perhaps more beneficial for tax purposes. SEP IRAs also work far better as self-employed retirement plans than do SIMPLE IRAs.

Sole plan

Another key difference between SIMPLE and SEP IRAs is that only the latter can be combined with other IRAs. If you start a SIMPLE IRA for your business, then it must be your only retirement plan.

Forms

Although your SIMPLE IRA provider may ask you to complete certain IRS forms, you'll never have to file any paperwork to set up or administer your plan. Your plan provider will take care of all paperwork for you.

Qualification

Any employee whom you paid at least $5,000 in any two previous years or whom you'll pay at least $5,000 during the current year qualifies for inclusion in your SIMPLE IRA. You can modify these requirements to make them less restrictive – i.e., to include all your employees regardless of their income or how long they've worked for your company. However, you cannot make your requirements more restrictive than the IRS' base-level criteria.

Contributions

The SIMPLE IRA considerations above are straightforward, but account contributions are where SIMPLE IRAs, like all retirement plans, get more complex. These are the contribution rules of SIMPLE IRAs:

  • Employee-matching contributions are required – up to 3% of each employee's income. For example, if one of your employees makes $50,000 per year and contributes $2,000 (4%) to their account, you only need to match $1,500 (3%) of this contribution. However, you must match at least 1% of employee contributions during two calendar years of any five-year period.

  • Alternatively, you can make nonelective contributions of 2% to all employee IRAs. This rule means that whether or not an employee chooses to contribute any money to their IRA, you must still contribute 2% of their income. (As with SEP IRAs but unlike with many other retirement plans, employees are not required to make annual contributions.)

  • For both of the previous contribution rules, you are only required to match or make nonelective contributions up to the first $290,000 of an employee's income for 2021. This means that a 2% contribution on a $300,000 salary isn't 2% of $300,000 – it's 2% of $290,000.
  • Employees cannot contribute more than $13,500 of their salary to a SIMPLE IRA in 2021. However, employees age 50 or older at the end of 2021 can contribute an additional $3,000 in catch-up contributions.

  • No matter how much money employees do or don't contribute, they are always fully vested in the money in their accounts. This means that your employees take ownership of your contributions the moment you make them.

Rollovers

After an employee's first two years on your company's SIMPLE IRA, they can transfer money to employer-sponsored retirement plans and non-Roth IRAs without paying taxes on it. During those first two years, tax-free rollovers are only available to other SIMPLE IRAs. Additionally, SIMPLE IRAs cannot receive funds from Roth IRAs.

Taxes

Administering a SIMPLE IRA can help lower your business taxes. That's because all contributions that your company makes to your employees' SEP IRA accounts are fully tax deductible. If you're a sole proprietor or a partner in your business, these tax deductions pass through to your personal income. However, your employees cannot deduct their own SIMPLE IRA contributions from their taxes.

All money in SIMPLE IRAs grows tax-deferred, meaning an employee won't pay taxes on the income they put into their retirement account. However, when your employees begin taking required minimum distributions (at either age 70.5 or 72, depending on when they were born), these withdrawals will be taxed as income.

If an employee withdraws money from their SIMPLE IRA before they're required to take minimum distributions, their withdrawals will be taxed as income. If employees younger than 59.5 withdraw money from their plans, they'll pay an additional 10% tax. This tax increases to 25% if taken during the first two years of the SIMPLE IRA's lifetime.

Pros and cons of SIMPLE IRAs

Like all retirement plans, SIMPLE IRAs' features and complexities give them certain advantages and disadvantages over other plans. That's why we've broken down the pros and cons of SIMPLE IRAs below – to help you make a more informed decision about your company's retirement benefits.

Pros of SIMPLE IRAs

  • They're simple and affordable to start and administer. Starting 401(k) retirement plans for your team is often an expensive and laborious process. With SIMPLE IRAs, your startup paperwork is minimal. You'll also pay less to start and administer your plan than you would with many other retirement plans.

  • There's no discrimination testing. Unlike 401(k) plans, SIMPLE IRAs don't require discrimination testing to ensure that your retirement plans benefit all employees equally. The absence of this requirement makes SIMPLE IRAs easier to manage.

  • There are no filing requirements. You're not required to file any paperwork with the IRS to set up or administer a SIMPLE IRA. You won't have to spend time on this task when you could be working on more important business matters – your SIMPLE IRA provider will handle this need for you.

Cons of SIMPLE IRAs

  • They have relatively low contribution limits. The SIMPLE IRA 2021 contribution limit of $13,500 and the catch-up contribution of $3,000 in 2021 are smaller than they are with several other plans. Yes, $13,500 is more than twice the contribution limit of traditional and Roth IRAs, but it's about two-thirds of the traditional 401(k) contribution limit. It's also a mere fraction of the 2021 SEP IRA contribution limit, which can reach $58,000 for certain participants.

  • There's no Roth version. With Roth IRAs, you can choose to pay taxes on contributions and not on withdrawals. SIMPLE IRAs do not allow for this inversion of IRAs' usual tax-deferred salary contributions and taxed retirement withdrawals.

  • They require employer contributions. If you were to offer your employees 401(k) plans instead of SIMPLE IRAs, you wouldn't have to match any employee contributions (though it would still be a meaningful gesture). However, SIMPLE IRAs fully require employer-matching contributions, potentially making them more expensive in the long run.

  • They penalize withdrawals. Although the vast majority of retirement plans penalize early withdrawals, not all do, so it's fair to classify this standard retirement plan drawback as a key disadvantage of SIMPLE IRAs.

How to set up a SIMPLE IRA

If the pros and cons above have persuaded you to start a SIMPLE IRA for your business, then you're in luck – setup is typically hassle-free and affordable. Here's how to get started:

  1. Complete IRS Form 5305-SIMPLE. Although SIMPLE IRAs have no official filing requirements, you may find it useful to complete this form. Alternatively, your SIMPLE IRA provider may fill it out for you, since this form officially designates your provider.

  2. Educate your employees on your SIMPLE IRA. During your SIMPLE IRA setup, tell your employees about the IRA and explain how their accounts will work. Employees who choose to participate can set the withholdings from their paychecks to fund their accounts and choose the assets into which they want their money invested.

  3. Create individual SIMPLE IRAs for your employees. To officially welcome an employee into your SIMPLE IRA program, you must create a SIMPLE IRA for them individually from your provider's dashboard. This typically takes just a few minutes.

To begin this process, consult our reviews of the best employee retirement plans. You'll find tons of helpful information in these reviews – and before you know it, you might be all set with a SIMPLE IRA that's great for you and your team.

Image Credit: Prostock-Studio / Getty Images
Max Freedman
Max Freedman
business.com Contributing Writer
Max Freedman is a content writer who has written hundreds of articles about small business strategy and operations, with a focus on finance and HR topics. He's also published articles on payroll, small business funding, and content marketing. In addition to covering these business fundamentals, Max also writes about improving company culture, optimizing business social media pages, and choosing appropriate organizational structures for small businesses.