Content of the material
- What is a SIMPLE IRA?
- SIMPLE IRA Tax Implications
- SIMPLE IRAs vs. Other Popular Retirement Plans
- Pros and cons of SIMPLE IRA plans
- How to Set Up a SIMPLE IRA
- SIMPLE IRA Withdrawal Rules
- How Does a SIMPLE IRA Work?
- Understanding the SIMPLE IRA
- Establish a SIMPLE IRA Plan
- Choosing a Financial Institution
- Three Steps to Set up a SIMPLE IRA Plan
- Execute a Written Agreement
- Annual Notice to Eligible Employees
- Set Up a SIMPLE IRA for Each Eligible Employee
- Timing of Setting Up a SIMPLE IRA Plan
- What Are the Pros and Cons of a SIMPLE IRA?
- 1. More flexibility and more options.
- 2. Easier and less expensive to set up and operate.
- 3. Plenty of tax advantages.
- 1. There’s no Roth option for SIMPLE IRAs.
- 2. Lower contribution limits.
- 3. Beware of steep withdrawal penalties.
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What is a SIMPLE IRA?
A SIMPLE IRA is a type of individual retirement account (IRA) that allows employers with 100 or fewer employees to contribute to the retirement funds of their employees without the startup or operating costs of other conventional retirement accounts. Self-employed individuals can also set up and contribute to a SIMPLE IRA.An employer must contribute to an employee’s SIMPLE IRA in one of two ways:
Through Matching Contributions Here, an employer matches the contribution of an employee to their SIMPLE IRA account. SIMPLE IRA rules require that the employer match should not exceed 3% of the employee’s annual compensation. For example, an employee named Mr. A — whose annual compensation is $10,000 — contributes $1,000 to his SIMPLE IRA each year. His employer will match that contribution up to $300 (3% of $10,000). Mr. A can stop such contributions at any time and still enjoy non-elective contributions. However, depending upon the rules of his SIMPLE IRA, he might not be able to resume making his own contributions until the next calendar year. Through Non-Elective Contributions If an employee chooses not to individually contribute to the plan, SIMPLE IRA rules dictate that the employer must still contribute an amount equal to 2% of the employee’s compensation up to annual limits ($305,000 in 2022). To continue our example scenario from above, an employee named Mrs. B also earns $10,000 annually but decides not to contribute to her SIMPLE IRA plan. In this case, her employer will still make its own contribution of up to $200 annually to her plan (2% of $10,000).
All the funds held in a SIMPLE IRA are owned by the employee. Moreover, the employee makes the investment decisions for their own account and, if the employer permits, can change the financial institution in charge of the account.
The available investment assets are the same as any other traditional IRA: stocks, bonds, mutual funds, ETFs, REITs and certificates of deposit (CDs).
Those looking to invest in more nontraditional assets, like cryptocurrencies and real estate, might instead consider a self-directed IRA.
SIMPLE IRA Tax Implications
Any contributions by an employee to a SIMPLE IRA grow tax-free. The contributions are only taxed at the time of withdrawal.
Contributions by an employer to a SIMPLE IRA are tax-deductible. The SECURE Act of 2019 grants a maximum $500 tax credit annually for employers that use a SIMPLE IRA with automatic enrollment. According to the IRS, automatic enrollment allows the “employer to automatically deduct a fixed percentage or amount from an employee’s wages and contribute that to the SIMPLE IRA plan, unless the employee has affirmatively chosen to contribute nothing or to contribute a different amount.”
SIMPLE IRAs vs. Other Popular Retirement Plans
Understanding SIMPLE IRAs requires differentiating them from other similar retirement plans.
First, how do they differ from a 401(k)?
UsersWhile a SIMPLE IRA is generally only suitable for small businesses with 100 or fewer employees, any business with any number of employees can offer a 401(k). MatchingEmployers can decide whether to contribute to a 401(k) plan. Employers who opt for a SIMPLE IRA must contribute. Under a SIMPLE IRA, only the employees have the option not to contribute.Contribution Limits401(k) plans have higher contribution limits than SIMPLE IRAs.EligibilityAnyone who is 21 years or older and has worked for a year is eligible for a 401(k). Employees must have earned $5,000 over any two-year period before the current calendar year and must be on course to earning at least $5,000 in the current year to qualify for a SIMPLE IRA.
How do SIMPLE IRAs differ from traditional IRAs?SIMPLE IRAs vs. Traditional IRAs
Set UpThe former are set up by employers while the latter are set up by individuals without regards to their employers.ContributionsConsequently, while both employers and employees can contribute to the former, only employees contribute to the latter.Contribution LimitsSIMPLE IRAs have higher contribution limits.EligibilityAs long as you earn income, you can open and operate a traditional IRA with your custodian. With a SIMPLE IRA, you must make a certain amount of money to qualify.
What about SEP IRAs? Though alike in many ways, SIMPLE IRAs do carry key differences.SIMPLE IRAs vs. SEP IRAs
MatchingOnly the employer contributes to a SEP IRA. On the other hand, a SIMPLE IRA allows both employers and employees to contribute. No one is mandated to contribute to a SEP IRA, while employers are mandated to contribute to a SIMPLE IRA. Contribution LimitsSEP IRAs have higher contribution limits when compared to SIMPLE IRAs.
Pros and cons of SIMPLE IRA plans
When considering a SIMPLE IRA, it’s important to understand the advantages and drawbacks of this type of plan. Some notable benefits of establishing a SIMPLE IRA plan for employees include:
- Like other types of employer-sponsored retirement plans, SIMPLE IRAs allow employee participants to defer part of their salaries on a tax-deferred basis. Contributions can be made through payroll deductions.
- SIMPLE IRA plans are relatively straightforward to establish.
- Employees are immediately 100 percent vested in all SIMPLE IRA contributions. As opposed to the majority of qualified plans, matching employer contributions immediately belong to employees and travel with them if they leave employment.
- Businesses may be eligible to receive a tax credit of up to $5000 per year (for the first three years from the plan’s inception) to help offset setup and administrative costs of establishing the plan.
- Employers do not have to file Form 5500 as part of the plan’s requirements.
There are also some disadvantages of setting up a SIMPLE IRA, some of which include:
- Contribution limits for SIMPLE IRA plans are lower than other workplace retirement plans, such as a 401(k) plan. In 2022, employees, sole proprietors, and self-employed workers under age 50 can contribute $14,000 to a SIMPLE IRA, versus $20,500 to a 401(k).
- Businesses are required to match employee contributions up to a certain percentage. Compare this to a retirement plan such as a 401(k), where employer contributions aren’t required.
- Employers must follow strict rules set by the IRS, including rules around withdrawals and transfers (see SIMPLE IRA rules section above).
How to Set Up a SIMPLE IRA
As the name implies, a SIMPLE IRA is often easier for a small employer to set up and administer than a 401(k) plan.
These plans require minimal paperwork for the employer and maintenance costs are low.
A SIMPLE IRA is established through a financial institution, such as a bank, which then administers the plan.
The plan provider will offer various investment options to choose from, such as stocks, bonds and mutual funds.
Each employee can choose which investments to include in their own SIMPLE IRA.Three Steps an Employer Must Follow to Establish a SIMPLE IRA
Select the type of SIMPLE IRA you want to provide. You must fill out IRS Form 5305-SIMPLE if you want to select the financial institution where employees will hold their IRAs, or fill out IRS Form 5304-SIMPLE if you want workers to pick the financial institution that will hold their account. Provide eligible employees with information about the SIMPLE IRA plan. Create separate SIMPLE IRAs for each eligible employee using Form 5305-S or Form 5305-SA.
If you’re an employee and want to sign up for a SIMPLE IRA at your job, your employer will have you fill out one of the forms above.
SIMPLE IRA Withdrawal Rules
Like other tax-advantaged retirement plans, you pay taxes at your current income tax rate when you withdraw from your SIMPLE IRA in retirement. Withdrawals made before age 59 ½ may be subject to a 10% penalty in addition to any taxes you owe. With a SIMPLE IRA, this penalty rises to 25% if you take the money out within two years of when you first started contributing to the plan.
You may be able to avoid the early withdrawal penalty if you have major unreimbursed medical expenses, have qualified higher education expenses or use what you withdraw to purchase a first home, among other qualified exemptions. You still have to pay the taxes on your early withdrawals, though.
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.1If 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 $3,000.2SIMPLE 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
Understanding the SIMPLE IRA
Employees can contribute a maximum of $13,500 annually in 2021 ($14,000 in 2022). The maximum is increased periodically to account for inflation. Retirement savers ages 50 and older may make an additional catch-up contribution of $3,000, bringing their annual maximum to $16,500 in 2021 ($17,000 for 2022).
One of the many major provisions, now law, under the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, the government will provide a maximum tax credit of $500 per year to employers who create a 401(k) or SIMPLE IRA plan with automatic enrollment.
The appeal of SIMPLE IRAs is that they have minimal paperwork requirements, just an initial plan document and annual disclosures to employees. The employer establishes the plan through a financial institution that administers it. Startup and maintenance costs are low, and employers get a tax deduction for contributions they make for employees.
To be eligible to establish a SIMPLE IRA, the employer must have 100 or fewer employees. Those who are self-employed or sole-proprietors are eligible to establish a SIMPLE IRA as well. 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. Employers can choose less restrictive participation requirements if they wish. An employer may also choose to exclude from participation employees who receive benefits through a union.
Establish a SIMPLE IRA Plan
Starting a SIMPLE IRA plan is easy to do!
Choosing a Financial Institution
You’ll need to choose a financial institution to serve as trustee of the SIMPLE IRAs to hold each employee’s/participant’s retirement plan assets. These accounts will receive the contributions you make to the plan. Alternatively, you can decide to let employees choose the financial institution that will receive their contributions.
Three Steps to Set up a SIMPLE IRA Plan
There are three steps to establishing a SIMPLE IRA plan.
- Execute a written agreement to provide benefits to all eligible employees
- Give employees certain information about the agreement
- Set up an IRA account for each employee
Execute a Written Agreement
- Use Form 5304-SIMPLE if you allow each plan participant to select the financial institution for receiving his or her SIMPLE IRA plan contributions.
- Use Form 5305-SIMPLE if you will deposit all SIMPLE IRA plan contributions at an employer-designated financial institution.
You adopt the SIMPLE IRA plan when you have completed all appropriate boxes and blanks on the form and you (and the designated financial institution, if any) have signed it. Keep the original form. Do not file it with the IRS.
Alternatively, you may use a prototype document. A mutual fund, insurance company, bank or other qualified institution usually provides these. You may also have an individually designed plan.
Annual Notice to Eligible Employees
You must notify each employee before the beginning of the election period of:
- The employee’s opportunity to make or change a salary reduction choice under the SIMPLE IRA plan;
- The employees’ ability to select a financial institution that will serve as trustee of the employees’ SIMPLE IRA, if applicable;
- Your decision to make either matching contributions or nonelective contributions;
- A summary description (the financial institution should provide this information); and
- Written notice that the employee can transfer his or her balance without cost or penalty if you are using a designated financial institution.
The election period is generally the 60-day period immediately preceding January 1 of a calendar year (November 2 to December 31). However, the dates of this period are modified if you set up a SIMPLE IRA plan in mid-year or if the 60-day period falls before the first day an employee becomes eligible to participate in the SIMPLE IRA plan.
If you set up your SIMPLE IRA plan using either Form 5304-SIMPLE or Form 5305-SIMPLE, you can give each employee a copy of the signed forms to satisfy the notification requirement.
Set Up a SIMPLE IRA for Each Eligible Employee
A SIMPLE IRA must be set up by or for each eligible employee and all contributions to the plan must go to it.
A SIMPLE IRA cannot be a Roth IRA.
Financial institutions authorized to hold and invest SIMPLE IRA plan contributions include banks, savings and loan associations, insurance companies, certain regulated investment companies, federally insured credit unions and brokerage firms. SIMPLE IRA plan contributions can be put into stocks, mutual funds and other similar types of investments. The investment options available at the institution where the SIMPLE IRA is located will determine what kinds of investment choices are available to the employee as he or she makes decisions about investing his or her SIMPLE IRA accounts.
You and your employees will receive a statement from the financial institutions investing your SIMPLE IRA plan contributions both at the time you make the first SIMPLE IRA plan contributions and at least once a year after that. Each institution must provide a plain-language explanation of any fees and commissions it imposes on SIMPLE IRA assets.
Timing of Setting Up a SIMPLE IRA Plan
You can set up a SIMPLE IRA plan effective on any date from January 1 through October 1 of a year, provided you did not previously maintain a SIMPLE IRA plan. This requirement does not apply if you are a new employer that comes into existence after October 1 of the year the SIMPLE IRA plan is set up and you set up a SIMPLE IRA plan as soon as administratively feasible after your business comes into existence. If you previously maintained a SIMPLE IRA plan, you can set up a SIMPLE IRA plan effective only on January 1 of a year. A SIMPLE IRA plan cannot have an effective date that is before the date you actually adopt the plan.
“Why SEP or SIMPLE IRAs are Hassle-free Retirement Plans” video – a discussion on two types of retirement plans (SEP and SIMPLE IRA) that are tailored for many businesses.
What Are the Pros and Cons of a SIMPLE IRA?
Before you decide whether or not a SIMPLE IRA is right for your business or whether or not you should invest in your company’s SIMPLE IRA, it’s important to keep in mind some of the advantages and limitations of these plans.
1. More flexibility and more options
With some other employer-based retirement plans, like a 401(k) or 403(b), you might have to work at that company for a certain number of years before what the company puts in actually belongs to you. That’s not the case with a SIMPLE IRA!
Whatever money your employer contributes to a SIMPLE IRA is immediately vested. That simply means every dollar that’s put into your account immediately belongs to you and you can take it with you whenever you leave the company.
Not only that, but while a typical 401(k) plan might be limited to just a handful of options, SIMPLE IRAs usually have a much larger menu of investments for you to choose from!
2. Easier and less expensive to set up and operate
One of the biggest benefits to opening a SIMPLE IRA is that they’re much easier to set up and less expensive to run than a typical 401(k) plan or other “qualified plans.” That’s because they have lower administrative costs and fewer regulations to worry about. That’s music to any business owner’s ears!
3. Plenty of tax advantages
For all of you small-business owners out there, you get a tax deduction for any contributions you make to your employees’ accounts. That’ll help take some of the pressure out of tax season!
1. There’s no Roth option for SIMPLE IRAs
Unfortunately, there isn’t a Roth IRA option available for SIMPLE IRA plans that would allow employers and employees to enjoy tax-free growth and tax-free withdrawals in retirement. But as your company grows and expands beyond what a SIMPLE IRA plan can provide, you might want to look at introducing a Roth 401(k) option to your team!
2. Lower contribution limits
Again, SIMPLE IRA contributions max out at $13,500 for most workers. That’s a few thousand dollars less than the contribution limit for a regular 401(k) plan, but it’s still a really good place to start!
Plus, you’re allowed to contribute to other retirement savings plans at the same time. So if you have another job that offers a workplace retirement plan or want to put money in a personal Roth IRA outside of work, go ahead and invest there too!
3. Beware of steep withdrawal penalties
Taking money out of your SIMPLE IRA (or any retirement account) should always be a last resort to avoid either bankruptcy or foreclosure. If you withdraw from a SIMPLE IRA within two years of opening it, you’ll pay a whopping 25% penalty. You should only put money in your account if you can keep it there for a long, long time (which is what you want to do anyway!).
You’ll also get hit with that 25% penalty if you do a rollover into anything other than another SIMPLE IRA during those first two years. So what’s the moral of the story here? Leave that money alone, people!
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