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What is a SIMPLE IRA? How Does it Work?

By Austin Kilham · November 04, 2021 · 4 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

What is a SIMPLE IRA? How Does it Work?

The SIMPLE IRA is one type of tax advantaged retirement savings plans to help self-employed savers and small business owners put money away for their future, including the SIMPLE IRA.

You may already be familiar with traditional individual retirement accounts (IRA), and a SIMPLE IRA, or Saving Incentive Match Plan for Employees, is one type.

Recommended: Understanding the Different Types of Retirement Plans

What Is a SIMPLE IRA?

SIMPLE IRA plans are employer-sponsored retirement accounts for businesses with 100 or fewer employees. If you’re your own boss and self-employed, you can set one up for yourself.

For small business owners, SIMPLE IRAs are an easy-to-manage, low-cost way to contribute to their own retirement while at the same time helping employees to contribute to their savings as well.

SIMPLE IRAs are relatively easy to put in place, since they have no filing requirements for employers. Employers cannot offer another retirement plan in addition to offering a SIMPLE IRA.

Recommended: Retirement Options for the Self-Employed

How Does a SIMPLE IRA Work?

In order for an employee to participate, including self-employed individuals, they must have earned at least $5,000 in compensation over the course of any two years prior to the current calendar year, or they must expect to make $5,000 in the current calendar year. It is possible for employers to set less restrictive rules for SIMPLE IRA eligibility. For example, they could lower the amount employees are required to have made in a previous two-year time. However, they cannot make participation rules more restrictive.

Employers can exclude certain types of employees from the plan, including union members who have already bargained for retirement benefits and nonresident aliens who don’t receive their compensation from the employer.

SIMPLE IRA Rules

When an employer sets up a SIMPLE IRA plan for themselves or their employees, they are required to contribute to it each year. They have two options: They can either make matching contributions of up to 3% of an employee’s compensation, or they can make a nonelective contribution of 2% for each eligible employee, up to an annual limit of $229,000 in 2021.

If the employer chooses the latter option, they must make a contribution to their employees’ accounts, even if those employees don’t contribute themselves. Contributions to employee accounts are tax deductible.

Eligible employees can choose to contribute to the plan, as well. In 2021, SIMPLE IRA contribution limits are up to $13,500 in deferrals. Those over the age of 50 can contribute an extra $3,000 in catch-up contributions, which brings their annual maximum contributions up to $16,500. Those contribution levels may change over time, as the government adjusts them to account for inflation.

Contributions reduce employees’ taxable income, which gives them an immediate tax benefit, lowering their income taxes in the year they contribute. Contributions can be invested inside the account and grow tax-deferred until the employee makes withdrawals when they retire.

IRA withdrawal rules are particularly important to pay attention to as they can be a bit complicated. Withdrawals made after age 59 ½ are subject to income tax. If you make withdrawals before then, you may be subject to an additional 10% or 25% penalty. Account holders must make required minimum distributions from their accounts when they reach age 72.

SIMPLE IRA Pros and Cons

While SIMPLE IRAs offer a lot of benefits, including immediate tax benefits, tax-deferred growth, and employer contributions, there are some drawbacks. For example, SIMPLE IRAs don’t allow employees to save as much as other retirement plans such as 401(k)s and simplified employee pension (SEP) IRAs.

In 2021, employees can contribute up to $19,500 to a 401(k) account, with an extra $6,500 in catch-up contributions for those 50 and older. Individuals with a SEP IRA account can contribute up to 25% of their employee compensation, or $58,000, whichever is less, in 2021.

The good news is employees with SIMPLE IRAs can make up some of that lost ground. Employers may be wondering about the merits of choosing between SIMPLE vs. traditional IRA, but they can actually have both.

Employers and employees can open a traditional or Roth IRA and fund it simultaneously. For 2021, total contributions to IRAs can be up to $6,000, or $7,000 for those ages 50 and older.

Here some pros and cons of starting and funding a SIMPLE IRA at a glance:

Pros

Cons

Easy to set up, with less paperwork than other retirement accounts, such as 401(k)s. Lower contribution limits than other plans, such as 401(k)s and SEP IRAs.
Employers have lower upfront and management costs to run the plan. Withdrawals made before age 59 ½ are subject to a possible 10% or 25% penalty.
Contributions are tax deductible for employers and employees. There is no Roth option that would allow employees to fund the retirement account with after-tax dollars that would translate to tax-free withdrawals in retirement.
There are no filing requirements with the IRS.

Establishing a SIMPLE IRA

If you’re interested in opening a SIMPLE IRA, banks and brokerages may have a plan, known as a prototype plan, that’s already been approved by the IRS.

Otherwise you’ll need to fill out one of two forms to set up your plan:

•   Form 5304-SIMPLE , allows employees to choose the financial institutions that will receive their SIMPLE IRA contributions.

•   You can also fill out Form 5305-SIMPLE , which means employees will deposit SIMPLE IRA contributions at a single financial institution chosen by the employer.

Once you have established the SIMPLE IRA, an account must be set up by or for each employee, and employers and employees can start to make contributions.

At the beginning of each annual election period, employers must notify their employees of the following:

•   Opportunities to make or change salary reductions.

•   The ability to choose a financial institution to receive SIMPLE IRA contribution, if applicable.

•   Employer’s decisions to make nonelective or matching contributions.

•   A summary description provided by the financial institution that acts as trustee of SIMPLE IRA fund, and notice that employees can transfer their balance without cost of penalty if the employer is using a designated financial institution.

The Takeaway

SIMPLE IRAs are one of the easiest ways that self-employed individuals and small business owners can help themselves and their employees save for retirement, whether they’re experienced retirement investors or they’re opening their first IRA. These accounts can even be used in conjunction with other retirement accounts and investment accounts to help individuals save even more.

Whether you choose a SIMPLE IRA or another retirement account, it’s important to begin investing as soon as possible. While SoFi does not offer a SIMPLE IRA, you can open a Roth or Traditional IRA on the SoFi Invest investment app and easily manage the account from your phone.

Photo credit: iStock/shapecharge


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