A SIMPLE IRA a can be a popular option for small businesses because they are truly “simple” to set up. They can also be an effective benefit tool for employers and employees. SIMPLE is an acronym for “Savings Incentive Match Plan for Employees”.
Establishing a SIMPLE IRA
As an employer, it is a fairly straightforward process to establish a SIMPLE IRA. Most major custodians charge no fees to set up the plan. By working directly with a custodian or through a financial advisor, you can select plan options and create accounts for each eligible employee. Administratively, employers coordinate with employees each pay period to determine if any changes to employee deferrals should be made. The deadline to set up a SIMPLE IRA for the current tax year is October 1st.
One requirement for employers hoping to set up a SIMPLE IRA plan is that the company must have less than 100 employees. While a SIMPLE IRA plan is much less expensive to set up and maintain, it does lack in overall flexibility. Unlike other retirement plans, employees cannot elect Roth (after-tax) contributions to allow for tax-free growth.
As an employee, you must meet the following criteria to become an eligible participant in a SIMPLE IRA:
- earn annual compensation of at least $5,000 in the last two years
- expected to earn at least $5,000 in the current year
Unlike a SEP IRA where only the employer can contribute money into employee accounts, a SIMPLE IRA allows for both employer and employee contributions into an employee’s account.
Employers have two contribution options for funding employee accounts. The first method is a flat 2% to every eligible participant whether or not the employee contributes to the account. This is called a non-elective employer contribution. The money is deposited into employee accounts every pay period and contributions are automatically vested; SIMPLE IRAs cannot be subject to vesting requirements.
The second method is a dollar-for-dollar match up to 3% of the employee’s salary. This means that for every dollar (up to 3% of the employee’s salary) the employee contributes into their account, the employer must match that amount. This is known as an elective contribution. For example, let’s assume John earns $100,000 per year. In order for him to receive the maximum contribution from his employer or $3,000, he must contribute at least $3,000 himself. By choosing the elective contribution option, business owners can save money in the long run if employees don’t contribute to their company’s retirement plan. The employer may also choose to reduce the matching percentage at any point. The IRS allows companies to reduce the company match from 3% down to as little as 1% in two years out of a five-year period. Employers may elect this option when businesses are experiencing financial hardship in a given year.
Employer contributions are always funded with pre-tax money, which allows business owners to receive a tax deduction for the entire amount contributed to employee plans.
Just like with other IRAs, there are limitations for amounts that individuals can contribute each year. In 2021, employees can contribute $13,500 annually to their SIMPLE IRA with pre-tax money. SIMPLE IRAs do not allow for Roth (after-tax) contributions by employees. For employees 50 years or older, the IRS allows you to contribute an additional $3,000 per year as a “catch-up” contribution. This increases the total annual contribution limit to $16,500 per year for employees over 50.
It’s important to note that these contribution limits increase periodically to keep up with inflation. You should review contribution limits from year to year in order to maximize your contribution potential.
If you plan to withdraw funds from a SIMPLE IRA, please note that you can potentially incur penalties.
Similar to other retirement plans, individuals who have not reached age 59 ½ and elect a distribution from their SIMPLE IRA are subject to pay ordinary income taxes and a 10% early withdrawal penalty. In this instance, individuals can avoid the 10% penalty if they have a wavier related to one of the few exceptions. Because SIMPLE IRA accounts are funded with pre-tax dollars, income taxes – federal and possibly state – are due when any distributions are made.
Another penalty that can be assessed upon distribution deals with timing and is significantly larger. Employees cannot withdraw funds from their SIMPLE IRA within two years of initial deposit. Otherwise, they will be charged a 25% penalty in addition to federal and state taxes owed. This two-year waiting period begins the day that money was first deposited into the SIMPLE IRA account.
Overall, establishing a SIMPLE IRA can be an effective retirement plan for small businesses. We recommend speaking with your tax accountant or financial advisor to determine if a SIMPLE IRA plan is a good option for your business.
If you have any questions, please reach out to our team here at Taylor Hoffman!
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