The United States Internal Revenue Service provides a number of tax-advantaged ways for people to save for retirement. One of these ways is through a Savings Incentive Match Plan for Employees Individual Retirement Arrangement, or a SIMPLE IRA. The following article will give you a broad understanding of what you need to know about SIMPLE IRAs.
How SIMPLE IRAs Work
Once a SIMPLE IRA is in place, an employer automatically deducts a certain amount of an employee's paycheck and submits it to the financial institution operating the SIMPLE IRA in the employee's name. The employer also has the option of matching these deductions with its own contributions into the employee's SIMPLE IRA. The financial institution then uses these funds to make investments for the employee. The employee does not initially have to pay income tax on the income that goes into the SIMPLE IRA – whether that income comes in the form of wage deduction or optional employer contribution. The funds in the account also grow tax-deferred until the employee retires, at which point the employee must pay income tax on the retirement distributions.
Contributions into a SIMPLE IRA consist of the following:
- Salary Reduction/Elective Deferral Contributions are regular contributions made as a specific percentage of employee income or as a flat amount.
- Catch-Up Contributions are special contributions that people of age 50 or older can make into their SIMPLE IRA accounts above and beyond the normal contributions. The total amount that can be made per year is limited.
- Employer Matching Contributions are contributions that employers make into employees' SIMPLE IRA accounts that are equal to the employees' individual elective deferral contributions. This is capped at 3 percent of each employee's total compensation.
- Employer Discretionary Contributions are contributions that employers make regardless of employees' contributions. This is capped at 2 percent of each employee's total compensation (up to $245,000) and must be made for all eligible employees.
While employer contribution limits into a SIMPLE IRA are determined according to employee contributions and employee income, employee contributions are set at flat amounts that usually go up year after year. As of 2012, the limitations for employee contributions are:
- $11,500 in salary reduction/elective deferral contributions into a SIMPLE IRA.
- $17,000 in total contributions into all tax-advantaged retirement plans, including SIMPLE IRA contributions.
- $2,500 in catch-up contributions.
SIMPLE Vs. Traditional IRAs
A SIMPLE IRA is different from a traditional IRA in multiple ways. However, the primary difference is that SIMPLE IRAs can only be set up by a qualified employer while a traditional IRA can be set up by any qualified individual. (Employers may set up SIMPLE IRA arrangements for their employees only when they employ fewer than 100 people.) However, keep in mind that even though a SIMPLE IRA must be set up by the employer, all contributions into the account become the property of the employee.
Advantages Of SIMPLE IRAs
A SIMPLE IRA plan is advantageous over other retirement savings options in a number of ways. For example:
- As its name implies, the institution and operation of a SIMPLE IRA program is relatively simple. Employers can institute them with minimal effort.
- The IRS does not require employers to file any annual financial reports.
- The costs associated with setting up and managing a SIMPLE IRA are minimal.
Disadvantages Of SIMPLE IRAs
Despite the advantages intrinsic to the SIMPLE IRA model, certain disadvantages often cause both employers and employees to prefer other options. For example:
- In a SIMPLE IRA plan, the types of investments that can be made with contributed funds are limited to stocks, bonds, mutual funds and similar financial instruments. A 401(k) plan, however, allows investors to put their tax-deferred income toward other types of investments as well, such as real estate and non-incorporated companies.
- Some investors prefer the Roth IRA or Roth 401(k) option over the SIMPLE IRA option. In Roth accounts, instead of making tax-free contributions and paying taxes on distributions after retirement, investors pay taxes on their contributions and receive tax-free distributions. This preference arises from an assumption of a relatively high rate of return on investments. (To learn more about Roth retirement accounts, see Traditional VS Roth: Which 401k Retirement Plan Should You Choose? and Differences Between Roth And Traditional IRAs.)
Setting Up A SIMPLE IRA
According to the IRS, if you are an employer, you may set up a SIMPLE IRA program for your employees and yourself by carrying out the following three steps:
- Fill out a 5304-SIMPLE or 5305-SIMPLE form. The first is for employers who intend to let employees pick their own financial institution while the second is for employers who intend to send all contributions to the same financial institution.
- Inform all employees of the SIMPLE IRA in writing. This written notice can include a copy of the aforementioned form and information about employee contributions, employer contributions and the selection of a financial institution (if you have selected the 5304-SIMPLE form).
- Contact a qualifying financial institution. Inform this institution about your intent to open SIMPLE IRA accounts for your employees. You may do this any time between January 1 and October 1.
Businesses that have more than 100 employees may not set up SIMPLE IRA accounts. If an employer has fewer than 100 employees upon the implementation of a SIMPLE IRA benefit framework but then subsequently grows beyond this point, that employer is still able to offer SIMPLE IRA accounts for two years. After these two years have passed, the employer must convert the SIMPLE IRA framework to some other type of retirement investment option.
The SIMPLE IRA is designed to be a simple, affordable way for small businesses to provide for their employees' retirement needs. While it has its disadvantages, it is often the best choice for businesses with limited resources. If another retirement investment framework is preferred later, SIMPLE IRA plans can be rolled over into other types of tax-advantaged plans after two years of participation.