What Is SIMPLE IRA and How It Works?

SIMPLE IRA is short for Savings Incentive Match Plan for Employees. A SIMPLE IRA is basically an employer-sponsored retirement plan in which the participants can save up to $26,00 pre-tax in deferrals and matching. Under the SIMPLE IRA plan, employers are required to match employee deferrals on a dollar for a dollar basis, which can fall between 1 and 3 percent. In order to use SIMPLE IRA, employers need to implement the plan before 1st October. While the plan has been available to employers for quite some time now, there’s still some confusion and misunderstandings regarding what the SIMPLE IRA plan is and how it can benefit a company and their employees. If you have been wondering the same thing, the following lines are going to provide you with all the information you need regarding the SIMPLE IRA plan. 

How Does It Work?

So, now that you have a good idea of what SIMPLE IRA is, it’s time to find out how the SIMPLE IRA plan works. SIMPLE IRA Is also known as a “poor man’s 401(k)”. This is mainly because it provides many of the same advantages offered by the 401(k) plan at lowered costs. That said, a SIMPLE IRA plan also has a lower contribution limit as compared to other options such as SEP IRAs. For instance, while a contribution for a SIMPLE IRA plan limits are lower as compared to other options, they still require the employer to match anywhere between 1% and 3% of the employee deferral, which makes it a great choice for employers who are looking to incentivize their employee’s retirement savings. 

However, unlike the 401(k) plan, a SIMPLE IRA plan can cost as low as $20 per employee for a single year. This is virtually nothing as compared to other options. Unlike the 401(k) plan, they also do not require any need for annual filings or need to be tested for compliance to ensure that the plan stays in balance. The lax attitude of the SIMPLE IRA when it comes to compliance testing is something that the plan shares with Safe Harbor 401(k)s. 

When it comes to contribution limits, SIMPLE IRAs fall under just $26,000 if the employer’s matching amount and deferrals are both maximized. This is nearly five times higher as compared to the limit on the traditional IRAs, which is only up to $6,000. That being said, limits for SIMPLE IRA contributions are much lower as compared to other alternatives such as 401(k) plants and SEP IRAs, since both of the latter options require a $56,000 contribution limit.

Keeping that in mind, SEP IRAs are also an attractive alternative to SIMPLE IRAS for many small companies and solopreneurs who have just a few employees in their companies. However, with SEPs, employers are required to fund all of their employee contributions and make them proportional to their own contribution. But, when it comes to SIMPLE IRA, the only major requirement of the plan is for the employer to match their employee deferrals between 1% and 3%. This dollar-to-dollar requirement makes SIMPLE IRAs far cheaper, especially for those businesses which have more than 8 employees.

Is SIMPLE IRA the Right Fit for Your Business?

As mentioned earlier, SIMPLE IRA plans are ideal for companies that have more than 8 employees and want to avoid the high cost of adopting the 401(k) plan. Small businesses can also benefit from adopting SIMPLE IRAs since it encourages employee savings through salary deferrals rather than through employer only contributions under the SEP IRA plan. Keeping that in mind, SIMPLE IRA is the ideal choice for those business owners who are not making any substantial profits with their business and are not in the right financial position of maximizing their contributions under either the 401(k) or the SEP. Since SIMPLE IRAs are cheaper than SEPs, business owners are able to defer their own income without the need to make a proportional contribution for each of their employees. Following are some situations where a SIMPLE IRA can be especially beneficial for an employer: 

  • Companies with many employees but low profitability – There are many smaller companies that offer their employees a decent living but are unable to produce any additional profits to make large contributions possible for the 401(k) plan or a SEP plan.
  • Smaller businesses with fewer employees – Owners of small businesses that have few employees prefer the SEP IRA, but the only downside to that option is that the SEP IRA requires the employers to fund all of their employee contributions. In this way, the SIMPLE IRA becomes a better solution, since its more economical for businesses with more than 8 employees. 
  • Companies that have few employees but high turnover – On the flip side, there are many companies with fewer employees who also find it hard to take full advantage of the 401(k) plan. In fact, for companies with fewer employees but a higher turnover, the owner as well as high-earning employees can be prohibited to maximize their contributions to the 401(k) plan, and still have to pay the full administrative costs.
  • Employers who want to contribute more for their employee – When it comes to the SIMPLE or SEP IRA, employers have a greater chance of making more contributions with the SIMPLE IRA without having to make proportional contributions as is the case when using the SEP plan.
  • Employers who are looking to encourage their employees to save for retirement – The SIMPLE IRA plan is the way to go for employers that want to encourage their employees to save for their retirement through salary deferrals. This means, they can save more as compared to traditional IRAs. These savings are also further incentivized by mandatory matching of the employer which leads to significant savings for the employee. 
  • Startups that are still going through growth – A SIMPLE IRA plan can be especially useful for young businesses that are still going through their growth phase. This is usually during the early years of a company, where the business owner needs to reinvest for continual growth of their business. Many businesses that are going through this phase are unable to afford the higher contribution limits of the 401(k) or the SEP. 

The Cost of a SIMPLE IRA

The biggest benefit of using a SIMPLE IRA plan is its cost effectiveness. When using a SEP IRA, business owners need to fund all of their employee’s contributions. When it comes to the traditional 401(k) plan, employers have to bear the significantly higher administrative costs. On the other hand, the SIMPLE IRA plan is considered to be a more cost-effective option since it costs between $10 and $20 per employee. The great thing about using the SIMPLE IRA plan is that it only requires a modest matching by the employer. The following are some of the costs that are associated with the SIMPLE IRA plan:

  • Custodian Fees – A custodian fee is basically a small charge of just $10 or $20 per year, which is to be given by the employer for each employee. This fee is to hold the SIMPLE IRA, which is then deducted from each individual employee’s account. 
  • Match Contributions – Under the SIMPLE IRA plan employers are required to match the employee salary deferral of an amount that falls between 1% and 3%. 
  • Payroll Provider – It is important to note that payroll provider charges are not always applicable. But, if they are an employer that chooses to use a payroll provider to streamline the payroll process, there will obviously be some additional costs. But, the good news is that this is not necessary when using a SIMPLE IRA plan. 

Contribution Limits: Things to Know for 2019

The SIMPLE IRA contribution Limits which have been established for 2019 is $26,000. These contributions are going to be divided into two categories. The employee salary deferrals are going to be limited to $13,000, and an additional $13,000 which will come from matching the employer’s contributions. The total amount of the SIMPLE IRA for an employee will largely depend on the matching formula used by the employer. It is important for business owners to note that they are required to match their employee deferrals by 1% and 3%. 

It is also important to note that these contribution limits are going to be higher than the traditional IRAs, while being lower than the 401(k) plan or SEPs. In this way, a SIMPLE IRA plan offers a good middle ground for employers and employees when it comes to determining the contribution limit that needs to be matched by the employer. This also ensures that the employer is able to keep their annual administrative costs as low as possible in the process. 

Deductible Tax for the SIMPLE IRA

When it comes to the SIMPLE IRA, the deferrals of employees are excluded from their taxable income, while matching contributions made by the employer are going to be tax detectible. This is a lot similar to the SEP IRA and 401(k) plans as well as traditional IRAs. Additionally, there is going to be a tax credit of up to $500 that’s going to be offered to business contributions that are tax deductible. This incentive is only going to be offered to those businesses that adopt the SIMPLE IRA plan. According to experts, this credit is going to help cover the costs of set up and administration, as well as the education of employees. The good news for business owners that provide SIMPLE IRA plans is that the incentive is going to be available to businesses for up to three years. 

Rules of SIMPLE IRA Plans

To be able to qualify for a SIMPLE IRA plan, businessowners are required to follow certain strict rules that have been laid out by the IRS. As compared to other retirement plans that are provided, the SIMPLE IRA plan is not considered as a “qualified” plan. This means an annual non-discrimination compliance test is not going to be required when providing a SIMPLE IRA plan. The following is a quick look at some of the rules that are required for the SIMPLE IRA plan:

  • Follow the right process – Under IRS rules, any employee that earns more than $5k during a calendar year is automatically eligible for the SIMPLE IRA plan. Those who are interested in the plan can enroll to start deferring income and receive matching contributions from their employer. But, it is up to the employer to choose a less severe eligibility requirements if they have been outlined in the plan’s documentation. 
  • Create a deferral matching program –This is also known as a compliance matching program, and employers are required to establish a deferral matching program that meets the requirements given by the IRS. All employers are required to match between 1% and 3% of the salary deferrals of their employees, and matching cannot fall below 3% for at least more than two years of the preceding five. Employers also have the option to contribute just 2% of the employee deferrals if they choose to do so. 
  • Eligibility of employees –To qualify for a SIMPLE IRA plan with the IRS, all employers need to offer employees the opportunity to enroll as soon as they are eligible and newly eligible employees need to be provided with a disclosure about the plan, its benefits, and all other details concerning employer matching, tax deferred retirement savings etc.
  • Immediate vesting – Common to other retirement plans, SIMPLE IRA plans also require immediate vesting of all contributions made for the employee. That said, it is not uncommon for some employers to use vesting schedules to deter their employees from leaving early. However, the good news for employees is that these vesting schedules are not available when it comes to the SIMPLE IRA plan. 

Ending Note

New SIMPLE IRAs must be formed between January 1st and October 1st of the year they take effect, with contributions made in the prior year prohibited by the IRS. A SIMPLE IRA plan can offer tremendous benefits to an employer and their employees which is why they are the preferred choice for startups and other small businesses that have less employees.