A SIMPLE IRA is an individual retirement account that allows employees and employers to contribute to a retirement plan. The full name is Savings Incentive Match Plan for Employees and it is ideally suited as a start-up retirement savings plan for small employers not currently sponsoring a retirement plan.
SIMPLE IRAs are primarily intended for small businesses with about 100 employees and self-employed individuals. Generally, you may participate in a SIMPLE IRA if you’ve received at least $5,000 in compensation during any two preceding calendar years and expect to earn at least that much during the calendar year of participation. Employers may also offer these accounts to employees who don’t meet these standards.
How does a SIMPLE IRA work?
A SIMPLE IRA is exactly what it sounds like. It is a simple and flexible plan you can use to save for retirement. Contributions to SIMPLE IRAs are tax-deductible, which could potentially push the business or employee into a lower tax bracket.
The plan is employer-sponsored, meaning that the employer is the primary contributor but employees can also make contributions to their accounts. The Internal Revenue Service (IRS) sets contribution limits that apply to both employers and employees.
Employees may contribute up to $13,500 in 2021 or $16,500 if they are 50 or older. This is less than the allowed maximum contribution for a 401(k) retirement plan, which is $19,500 ($26,000 for those aged 50 or older), but SIMPLE IRA account holders may participate in another employer-sponsored plan and make contributions up to a total of $19,500.
Employers have two options to contribute to the SIMPLE IRAs of their employees.
Option 1. Dollar-for-dollar match of employee contributions up to 3% of each employee's compensation. This can be reduced to as low as 1% in any 2 out of 5 years).
Option 2. Contribute 2% of the employee's compensation. The maximum annual amount in this case is $290,000 for the 2021 tax year.
Employer contributions are mandatory while employee contributions are optional.
Investment options and taxation
The investment choices in SIMPLE IRAs tend to be more numerous than those available in 401(k) plans. You can access a full range of investment choices, including stocks, bonds, options, ETFs, mutual funds and any other investments offered by the IRA provider.
In terms of taxation, you can take advantage of the following benefits. Your contributions reduce your taxable income for the year, so the more you put away in the account, the lower your annual tax bill will be. The invested money will grow tax-deferred until it’s withdrawn at retirement but you will have to pay income taxes when you take out money.
Be careful with early withdrawal, as SIMPLE IRA rules tend to be punitive. As with many tax-advantaged savings accounts, if you make a withdrawal before the age of 59½ without a qualifying reason, such as the need to pay a large medical bill, you must pay a 10% early-withdrawal penalty. Note that SIMPLE IRAs charge a 25% early-withdrawal penalty for non-qualified withdrawals within the first two years of owning the account. This comes on top of whatever income taxes you owe on the withdrawn money.
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