How Simple Are Simple IRAs?

Individual retirement accounts (IRAs) are a popular way of saving for retirement. Some types of IRAs, such as the Simple IRA, are employer-sponsored. This is an easy retirement savings option for both employers and employees. However, they do come with a few disadvantages as well.

What are Simple IRAs?

Simple IRA plans are a type of employer-sponsored retirement plan available to small businesses. For a business to qualify for Simple IRAs, an employer must have 100 or fewer employees. For employees to qualify, they must have earned at least $5,000 in compensation during any two previous calendar years. The employee must also be expected to earn at least $5,000 in the current year.

Employer contributions to their employees' accounts are mandatory. But the employers get options as to how they'd prefer to contribute. They can choose to either:

  • Make a non-elective contribution of 2% of the employee's salary
  • Match employee contributions up to 3% of their salary

"Simple" has two meanings in this context. First, it's an acronym for "Savings Incentive Match Plan for Employees." Second, Simple IRAs are commonly easy on both employers and employees. Two primary hallmarks of their simplicity are low management costs and a reduced need for paperwork.

What are the downsides of a Simple IRA for employees?

While Simple IRAs can be powerful retirement planning and investing tools, they also come with some downsides for the employees. This is especially true when compared to other retirement plans like a 401(k) or SEP IRA.

For instance, Simple IRAs have lower contribution limits than other workplace retirement plans. The annual limit in 2022 for those under age 55 is $14,000; for a 401(k), it's $20,500.

Catch-up contributions also fall short of 401(k) limits. In 2022, employees age 50 and higher can contribute an additional $6,500 to their 401(k). Those same employees can only contribute an additional $3,000 to their Simple IRA.

Additionally, employers that chose the 3% option are only required to make contributions if the employee does so first. This means that, if the employee fails to contribute to their account, the employer is under no obligation to contribute, either. These two factors can really make a difference in an employee's total retirement savings.

Lastly, I'd like to mention that these plans do not offer the ability to take out a loan against the account balance. Also, rollovers have limitations and waiting periods employees will need to consider.

Please note that early withdrawals from a Simple IRA do come with a federal tax penalty. However, it's generally the same penalty as taking an early withdrawal from a 401(k). An early with from either account incurs an additional 10% income tax penalty on the amount you withdraw. A withdrawal is considered early when the account owner is under the age 59 and 1/2.

What are the downsides of a Simple IRA for employers?

While many employers may be attracted to Simple IRAs for their low costs and flexibility, there are also downsides to consider. If the employer chooses the non-elective contribution option, it's mandatory for the employer to contribute 2% of each employee's salary. If the business has a bad year or two, matching 2% of total employee compensation could become a heavy burden.

The employer should also consider how a Simple IRAs other limitations may affect their ability to optimize their personal retirement savings. Take into consideration that these plans have:

  • Lower contribution limits relative to other workplace retirement plans
  • Restricted rollover capabilities
  • An inability to have Roth versions of a Simple IRA

These could all have drastic effects on how an employer can optimize their retirement planning and investing.

Are there tax advantages to having a Simple IRA?

For both employees and employers, Simple IRAs have some advantages when it comes to paying taxes. This is a benefit it shares with 401(k) plans.

For the employee, both their contributions and any growth within the IRA are tax-deferred. Keep in mind that even though contributions are tax-free, withdrawals and distributions are not. Because contributions are also "pre-tax," they're deductable on an employee's tax returns. This offers additional tax savings by lowering their overall taxable income. The lack of capital gains tax while the money grows should help the money compound and grow at a faster pace. This can help maximize retirement savings.

If the employer uses a Simple IRA for their own retirement, they will receive the same tax benefits as the employees. Also, the contributions the employer provides to their employees plans are a tax deductible expense.

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