What Is a SIMPLE IRA and How Does It Work? (2024)

What Is a SIMPLE IRA?

With so many differentsmall business retirement plansto choose from, it can be hard to decide which one is best for you. That’s why it’s important to know what each one offers. If you’re wondering, “What is a SIMPLE IRA?” it turns out it’s what it sounds like. It’s an easy-to-manage savings plan that lets you put tax-deferred money aside for retirement. Money in this account gets invested in a similar way to traditional IRAs.

SIMPLE IRA, which stands for Savings Incentive Match Plan for Employees Individual Retirement Accounts, is employer-sponsored. This means it is offered to employees through a business. These types of retirement plans are made specifically for small businesses with 100 or fewer employees. Your employees can participate in the plan if they made at least $5,000 during any two previous years and expect to make that much in the current year.

Many small employers use SIMPLE IRAs because they’re easy to set up and the costs to manage them are low. But these types of plans also have to follow specific rules set by the IRS. Whether SIMPLE IRAs are the best choice for you and your employees depends on your business.

How Does a SIMPLE IRA Work?

With a SIMPLE IRA, you and your employees can put a percentage of pay aside for retirement. The money will grow tax-deferred until it’s withdrawn at retirement. So, you won’t have to pay taxes on your investment growth, but you will have to pay income taxes when you take out money.

As with other retirement savings plans, there is a limit to how much you can put into your SIMPLE IRA. In 2020, you or your employees can’t put more than $13,500 into this type of account.¹

If you’re age 50 or older, your SIMPLE IRA plan may let you make catch-up contributions. This means you’re allowed to put more money into your retirement savings account. In 2020, the IRS limited catch-up contributions for SIMPLE IRAs to $3,000.²

SIMPLE IRAs require employers to match employee contributions:

• Up to 3% of your employee’s compensation
• At least 1% for no more than two out of five years

Your business can also make a 2% non-elective contribution to your employees’ SIMPLE IRA accounts. This means your business makes a contribution to all employees, even if they don’t contribute themselves.

Pros and Cons of a SIMPLE Retirement Plan

As important as it is to know thebenefits of retirement plans, it’s equally crucial to know thedownsides of SIMPLE IRAs. Knowing the pros and cons can help you decide which plan works best for your business.

Pros of SIMPLE IRAs:

• Minimal paperwork to set up:Depending on the provider, you may be able to set up a SIMPLE IRA online. If you have to fill out paperwork, it’s generally less than what you’d complete to set up another account, such as a 401(k) plan.
• Low startup and maintenance costs:Some retirement plans charge costly fees to open and maintain accounts. With SIMPLE IRAs, your business typically has lower upfront and managing costs.
• Money put into the plan is tax deductible:You and your employees can deduct contributions on tax returns.
• No IRS filing requirements:Your plan provider handles reporting requirements to the IRS.

Cons of SIMPLE IRAs:

• Employer-matchingrequirement:The IRS requires businesses to match employee contributions dollar for dollar, up to a certain percentage.
• Lower contribution limit:Other retirement accounts have higher contribution limits. For example, the 2020 contribution limit for 401(k) plans is $19,500 and $6,500 for catch-up contributions.³
• Withdrawing requirements:You can’t withdraw money from your SEP IRA until you reach age 59½. If you take money out before then, you’ll have to pay a 10% penalty and income taxes on your withdrawal.
• No Roth contributions:There’s no option to have a Roth version of your SIMPLE IRA. So, you can’t fund your account with post-tax money to avoid paying taxes when you withdraw the money.

Setting Up a SIMPLE IRA Plan

The ease of setting up SIMPLE IRAs is one of the main advantages. Most banks and financial institutions have IRS-approved prototype plans you can use. This means you may be able to set up your specific plan with just one form.

Otherwise, you may have to complete:

• Form 5304-SIMPLE: Allows your employees to choose their own financial institution for receiving SIMPLE IRA contributions.
• Form 5305-SIMPLE: Designates one financial institution all SIMPLE IRA contributions will go to.

After your SIMPLE IRAs are set up, you and your employees can choose to make regular pre-tax contributions through payroll deductions. You can also pick how your money gets invested. For example, you can set up your account to invest in mutual funds. Your SEP IRA grows tax-deferred until you make withdrawals.

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