If you're the owner or employee of a small business, you might have heard of a SIMPLE IRA or a SIMPLE 401(k). The two retirement accounts are similar, but there are some key differences between them. It's crucial for business owners to understand them to choose the right type of account for their employees.
As an employee, you might not have any control over the plan your company uses, but it still helps to understand how yours works so you know what to expect. Here's a brief guide to both types of accounts.
What are SIMPLE retirement accounts?
SIMPLE stands for Savings Incentive Match Plan for Employees, but it's usually referred to by its acronym. These are retirement savings accounts aimed at small businesses that may find it cost-prohibitive to establish a traditional 401(k) for employees.
They're designed for companies with 100 employees or fewer, and both the SIMPLE IRA and the SIMPLE 401(k) enable workers to set aside up to $13,000 in 2019 and $13,500 in 2020. Those 50 or older may contribute an extra $3,000 per year in catch-up contributions. These limits aren't as high as what you'd find with a traditional 401(k), but they are much higher than what employees would be able to contribute if all they had access to was an IRA.
Both accounts also require mandatory employer-matching contributions to qualifying employees' accounts, though they differ in what they consider a qualifying employee (more on that below). Employers can choose to match employee contributions up to 3% of their salary, or else they can make fixed contributions of 2% of each qualifying employee's salary. If they choose the latter approach, they must contribute funds to each qualifying employee's account even if the employees don't set aside any of their own funds for retirement.
If the company falls upon hard times, it may reduce its matching contribution as long as it doesn't go below 1% and isn't reduced for more than two years out of a five-year period. All employer-matched funds are immediately vested, as required by federal law, so employees get to keep them even if they leave the company after a few months.
Employers must open a SIMPLE 401(k) or a SIMPLE IRA between January and October of a given year to ensure that employees have adequate time to contribute to the accounts if they choose to. They cannot offer qualifying employees an alternative retirement plan to contribute to if they also have a SIMPLE plan, but they may offer another plan to employees who do not qualify for the SIMPLE plan if they choose.
Differences between SIMPLE IRAs and SIMPLE 401(k)s
SIMPLE IRAs and SIMPLE 401(k)s differ in whom they consider to be a qualifying employee. For SIMPLE IRAs, a qualifying employee is anyone who has earned at least $5,000 from the company in each of two years in the past and is expected to earn at least $5,000 in the current year. SIMPLE 401(k)s define qualifying employees as an employee 21 or older who has received at least $5,000 in compensation from the company in the previous calendar year.
The two accounts also have different rules on employer-matching contributions for high-earning employees. With a SIMPLE IRA, employers making matching contributions must match 3% of the employee's salary each year, assuming they haven't reduced contributions for the year. But SIMPLE 401(k) matching employer contributions and SIMPLE IRA and SIMPLE 401(k) nonelective contributions are subject to a compensation cap. This is $280,000 in 2019 and $285,000 in 2020.
It's unlikely, but if an employee earns more than the compensation cap for the year (say, $300,000), the employer is only legally obligated to match 2% or 3% up to the limit for the year. This means that if the employer offers a 3% matching contribution on its SIMPLE 401(k), the employees might get less than the match they would've been entitled to if the company offered a SIMPLE IRA. If the employer chose to make a 2% nonelective contribution, the type of account wouldn't matter as nonelective contributions for both accounts are subject to the same compensation cap.
The other key difference between the two types of accounts is that SIMPLE 401(k)s can allow loans, while SIMPLE IRAs do not. But just because you're able to take out a loan doesn't mean you should. This is rarely a good idea because it may impede the growth of your retirement savings, even if you pay it back with interest. Plus, if you don't pay back the loan within the allotted time, the government considers the outstanding balance a taxable distribution, and it'll raise your tax bill.
Which type of SIMPLE account is better?
Both types of accounts have their pros and cons. The one that's better depends on your status as employee or employer and your unique circumstances.
For most workers, the type of account isn't going to significantly affect how much money they're able to contribute to their retirement savings or what they'll get for an employer match. But it still pays to understand how these SIMPLE accounts work so you know what you can expect.