Simple IRA Basics

Simple IRA stands for Savings Incentive Match Plan for Employees. It is a retirement savings plan designed for small businesses and self-employed individuals. It works a lot like a Traditional IRA in that contributions are tax deductible and your investments grow tax deferred until you make withdrawals in retirement after the age of 59 ½. However, unlike a Traditional IRA, the account holder’s employer makes contributions to the employee’s plan, which is similar to the 401k plan.

Who is eligible to establish a Simple IRA?

Any employer (including self-employed individuals, tax-exempt organizations, and governmental entities) with no more than 100 employees can establish a Simple IRA. There is no income eligibility requirement to set one up, unlike the Traditional or Roth IRA.

Who can participate?

To participate in the plan, employees must have earned at least $5,000 in compensation in any two previous calendar years and be expected to earn at least $5,000 in the current year.

How are the contributions structured?

The contribution limits have increased from $12,500 in 2018 to $13,000 in 2019. The catch-up contribution limit remains the same at $3,000, so an individual who is 50 years or older in 2019 can contribute a total of $16,000 to his or her Simple IRA. This is a significantly higher limit than the Traditional IRA which in 2019 is $6,000 annually for under 50 years of age, and $7,000 for those over age 50. If desired, employees can contribute 100% of their income into a Simple IRA.

There are two contribution formulas to choose from:

1) Matching contributions:

Employer will match contributions up to 3% of compensation up to the annual limit. The employee will not receive any contribution from the employer if the employee does not contribute. There is an option for the employer to reduce the matching to as low as 1% in 2 out of 5 consecutive years.

2) Nonelective contributions:

The employee does not have to contribute anything to the plan, but the employer must contribute 2% up to the annual limit. The employee can contribute up to the maximum. An employer can use less restrictive participation requirements, but not more restrictive ones.

What are the investment options?

The Simple IRA plan gives the investor the discretion of what exactly you want your money invested into. You have the option to buy individual stocks, mutual funds, ETFs, or CDs. Money invested in the plan is automatically 100% vested. This is considerably different compared to most 401(k)s, where you would be limited to the investment options that your employer provides you.

Despite the benefits that make this type of retirement plan attractive, there are some drawbacks:

  • The employer cannot have other retirement plans besides the Simple IRA provided to the employees.

  • Simple IRAs have an earlier establishment deadline of October 1st of the tax year. All other IRA plans can be set up by April 17th of the following year.

  • There is a two year distribution rule for withdrawals. If you withdraw funds from a Simple IRA before the two years of participation are satisfied, there is a 25% penalty and a 10% penalty for each withdrawal after that period.

For example: If you change employers within two years of starting your contributions and you want to roll your money into a new 401k account, you could not do so within the first two years. You can roll it into another Simple IRA with no fee, but if you roll it over into any other retirement plan, there is a 25% early distribution penalty.

  • If you want to replace the Simple IRA to a 401k or SEP, you must wait until following year, you are unable to terminate them mid-year.

  • The assets may not be used as collateral.

  • The IRS does not permit loans to be taken out from a Simple IRA.

With higher contribution limits than a Traditional or Roth IRA, more investment options than most employer-sponsored retirement plans, and low start-up and maintenance costs, a Simple IRA can be an appealing retirement savings option for small businesses and self-employed individuals. It is important to weigh the benefits and limitations of the plan before making a decision if this is the right retirement plan for your business.

Carol Chaudet

(Last Updated 6/30/2019)