SIMPLE IRA Vs. 401(k) For Small Businesses
Determining which type of retirement savings plan to offer employees is often a difficult decision for small business owners. We'll demystify two common types of plans so that business owners can decide which one works the best for them.
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Retirement Savings Plans for Small Businesses
Offering a retirement savings plan helps startups or small businesses attract and retain top talent. Employers can deduct their share of any combined employer/employee contributions which creates savings for the business, while employees' pretax contributions have an immediate positive impact on their paychecks.
Two of the most common types of retirement savings plans are 401k and SIMPLE IRA plans. 401k plans get their name from a section of the Internal Revenue Service ((IRS)) code while SIMPLE stands for Savings Incentive Match Plan for Employees. Below, we'll examine the advantages and disadvantages of both types of plans to help small business owners and the self-employed determine which plan is right for them.
Differences Between SIMPLE IRA & 401k
| 401k | SIMPLE IRA | |
| Eligibility | Must offer to those age 21 or older with a minimum of 1 year of employment, optional for those younger than 21 and those who have been employed for less than 1 year. | Must offer to employees who have earned at least $5,000 in any of the two previous years or those who are expected to earn at least $5,000 in the coming year. |
| Company Size | Any number of employees. | Less than 100 employees. |
| Contribution Limits | Maximum of $20,500, with a $6,500 catch-up for those age 50 or over. | Maximum of $14,000, with a $3,000 catch-up for age 50 or over. |
| Matching Rules | Not including any catch-up contribution, the combined employee/employer contribution cannot exceed whichever is less: 100% of the employee's total compensation or $61,000 in 2022. | Either a dollar-for-dollar match of up to 3% of an employee's total annual compensation or a flat 2% of the employee's compensation up to $305,000 in salary in 2022. |
| Cost to Manage | Initially between $500-$2,000 with a potential per-participant fee from third-party administrators (if hired) of $15-$60/yr. | Financial institutions usually charge a low annual maintenance fee such as $25 per participant or a flat fee such as $350 per year. |
| Investment Options | Curated by the employer and the 401k plan administrator | Whatever investments are available at the financial institution holding the SIMPLE IRA accounts. |
401k vs. SIMPLE IRA Eligibility
An employer must offer participation in a 401k plan to employees who are age 21 or older and who have a minimum of one year of employment. If they choose to do so, an employer can offer participation to employees younger than 21 and those who have worked for the company for less than one year.
Employers must offer participation in a SIMPLE IRA plan to their employees who have earned at least $5,000 in any of two preceding calendar years or those who are expected to earn at least $5,000 in the coming year. This opens the door to participation for part-time or gig workers.
Company Size
Any size business can offer one of the several types of 401k plans while a business must have fewer than 100 employees to offer a SIMPLE IRA plan. Employers who have set up a SIMPLE IRA plan but cross the threshold of 100 employees may continue with the plan for two additional years. This favors fast-growing start-ups.
Contribution Limit Comparison
In 2022, employees can contribute up to $20,500 a year into a 401k account, however, those over age 50 can make an additional catch-up contribution of up to $6,500, bringing their total yearly contribution to $27,000.
Employees can contribute a maximum of $14,000 in 2022 into a SIMPLE IRA account, but those over 50 can contribute an additional $3,000 catch-up, bringing their total to $17,000 yearly.
Matching Rules
With 401k plans, employer matching contributions are voluntary while with SIMPLE IRA plans, employer contributions are mandatory.
401k
Employers typically contribute either a percentage of an employee's 401k contribution or a percentage of an employee's yearly salary. In cases where an employer matches 100% of an employee's contribution, there is usually a maximum amount in dollars or as a percentage of the employee's contribution or yearly salary.
For employees, employer contributions are essentially free money, and if it is financially feasible, employees should contribute the maximum amount they can to their 401k account to take advantage of the matching employer contribution.
Employees participating in 401k plans often don't gain full access to their employer's matching contributions for a period of time and this is called vesting. The most common length of time before employees are fully vested is three years, with vesting schedules such as access to 20% of the match after one year, 40% after two years, and 100% after three years also being common. Vesting is a way for employers to hang on to employees who will want to continue their employment until they fully vest.
SIMPLE IRA
Matching rules for a SIMPLE IRA are stipulated as either a dollar-for-dollar match of up to 3% of an employee's total annual compensation, or a flat 2% of the employee's compensation up to $305,000 in 2022.
Cost to Manage
Initial employer 401k startup costs are typically between $500 and $2,000 with the federal government providing a tax credit for some of these costs. Most companies hire a third-party administrator (TPA) to manage their 401k plans, and employers are also responsible for:
- Creating a plan document
- Selecting investment vehicles
- Sending employees required participant disclosures
- Approving and administering loans against accounts
- Approving distributions and rollovers
- Returning a 401k provider’s year-end questionnaire
- Filing IRS Form 5500
- Reviewing data used in annual compliance testing to ensure more highly paid employees are not being favored
There may also be a per-participant fee of between $15 to $60 a year.
To set up a SIMPLE IRA plan, most financial institutions don't charge a setup fee, but they do charge a low annual maintenance fee, typically $10 to $25 per participant, or a yearly fee per participant. Financial institutions may also charge a fee when a SIMPLE IRA account is closed or a balance is transferred.
Investment Options
401k plans allow participants to invest in mutual funds which can include index funds, large-cap and small-cap funds, foreign funds, real estate funds, and bond funds.
Contributions into SIMPLE IRA accounts can be invested in individual stocks and bonds as well as mutual funds, and employees make the investment decisions for their own accounts.
Pros & Cons of a 401k vs. SIMPLE IRA
Benefits of a 401k
- Optional vs. mandatory contributions: while employer contributions to a SIMPLE IRA plan are mandatory, for a 401k plan employer contributions are optional unless the 401k plan has a "safe harbor" provision. This ensures that all eligible plan participants receive an employer contribution, and in exchange for making a fixed employer contribution, employers can opt out of 401k non-discrimination testing.
- Vesting schedules: for SIMPLE IRA plans, employer contributions vest immediately, while for 401k plans there can be a waiting period ranging from a year up to three years.
- Contribution limits: for small-business owners who may be trying to maximize their own retirement savings dollars, a 401k plan's higher contribution limits, especially for high earners, favor it over a SIMPLE IRA plan.
- Roth equivalents: SIMPLE IRA plans don't offer Roth equivalents while 401k plans do. A Roth 401k is funded with after-tax contributions, allowing distributions after retirement to be tax-free. Distributions from a SIMPLE IRA in retirement are taxed at the federal and state levels according to the employee's tax bracket at that time. The IRS does allow employees to participate in both a SIMPLE IRA and a Roth IRA at the same time.
- Multiple plans: after setting up a SIMPLE IRA plan, an employer cannot maintain any other type of retirement plan, while those setting up a 401k plan can set up other types of retirement plans.
- Profit-sharing: employers can include an explicit profit-sharing plan as part of their 401k plan while SIMPLE IRAs do not allow profit-sharing contributions.
Drawbacks of Offering a 401k Plan
- Costs: expenses incurred in setting up a 401k plan and administering it can be high.
- Regulations: 401k plans are regulated by the IRS and the Department of Labor, and the plans' rules and regulations are stipulated in the Employee Retirement Income Security Act (ERISA) and can be both complex and expensive.
Pros & Cons of SIMPLE IRA vs. 401k
Benefits of a SIMPLE IRA
- Profit-sharing: the profit-sharing contributions possible with a 401k plan allow business owners to funnel money to themselves and to key employees. 401k plans can be combined with cash balance retirement plans, allowing for over $200,000 in pretax retirement savings, depending on age. SIMPLE IRA plans do not allow profit-sharing contributions, and they can't be combined with any other employer-sponsored retirement plan, limiting employer contributions to no more than 3% of an employee's compensation.
- Mandatory contribution: for companies whose profits fluctuate from year to year, a SIMPLE IRA's mandatory contributions may create a strain. With a 401k plan, an employer can choose whether or not they want to contribute to employee's accounts, and how much they want to contribute.
- Vesting schedules: vesting schedules aren't allowed for SIMPLE IRAs, while with a 401k, a vesting schedule may create a good reason for employees to stick around.
- Setup: all that's required to set up a SIMPLE IRA is filling out one of either of two IRS forms, creating an account for each employee at a financial institution, and providing notice of the plan to each eligible employee. Setting up a 401k plan involves sending notices to and enrolling employees, depositing contributions into participant accounts, performing annual nondiscrimination testing, and filing a form with the IRS at the end of every year.
Drawbacks & Limitations of a SIMPLE IRA
- Mandatory contribution: if an employer chooses the 2% contribution option, they must contribute to an employee's account whether that employee contributes or not.
- Rollovers: funds contributed to a SIMPLE IRA can't be rolled over into another retirement savings plan for two years.
- No Roth options: a SIMPLE IRA has no versions of a Roth IRA or a Roth 401k, which means that accounts can't be funded with post-tax money which would allow distributions after retirement to be tax-free.
- Termination: SIMPLE IRAs can’t be terminated mid-year, but only once a year on January 1st.
Alternative Retirement Plans for Small Businesses
Two types of alternative retirement savings plans for small businesses are:
- SEP IRA
- Solo 401k
"SEP" stands for Simplified Employee Pension and it differs from a SIMPLE IRA in that a SIMPLE IRA allows both the employer and the employee to make contributions, while a SEP IRA only allows the employer to make contributions, both for themselves and for their employees.
A SEP IRA allows up to 25% of income to be contributed tax-deferred. In 2022, a maximum of $61,000 can be placed into each participant's SEP IRA account. Compare that with the $14,000 maximum for a SIMPLE IRA. SEP IRA account holders are immediately vested, and they can transfer the money in their SEP IRA account to other qualified retirement savings plans or convert it to a Roth IRA, subject to transfer rules between plans.
A Solo 401k is a traditional 401k plan that covers only a business owner and his or her spouse. These plans have the same rules and requirements as any other 401k plan.
Choosing Which Is Best For Your Business
The high contribution limits and profit-sharing aspects of 401k plans make them attractive to business owners who want to maximize their savings and attract and retain talented employees.
For startups that are trying to plow their profits back into the company as well as attract top talent, the lower setup and administrative costs of SIMPLE IRAs make them a better option. Whichever plan you choose, be sure to keep a close eye on the plan administrative costs charged by the financial institution administering your plan.
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