If you are self-employed, you have no shortage of options when it comes to selecting a retirement account for your business. That’s why we’re in the middle of a series of blog articles that describe various types of retirements accounts, their rules, and pros and cons. First, we discussed good old fashioned Traditional and Roth IRAs. Then we discussed a SEP IRA. Now, we’re ready to describe the specifics of a SIMPLE IRA, which is an acronym for savings incentive match plan for employees. The government sure does love a good acronym!
SIMPLE IRA Contribution Rules
If you’re currently self-employed, you’ll need to understand the rules around how much you can contribute each year. Thus far, we’ve discussed accounts that only an individual can contribute to (Traditional and Roth IRAs) and an account that only the employer can contribute to (SEP IRA). With the introduction of SIMPLE IRAs, things get a bit more complicated. Both the employer and the employee can contribute to a SIMPLE IRA.
- Employees can contribute up to $14,000 for 2022. And those aged 50 or older can add a $3,000 catch-up contribution. Employee contributions are also limited to their salary, so someone who is only earning $12,000, for example, could not contribute the full $14,000.
- The employer can choose one of two contribution options:
- Option A – 3% match, which means the employer will contribute whatever the employee contributes, maxing out at 3% of the employee’s salary. This option encourages employee participation.
- Option B – 2% contribution to each eligible employee, regardless of whether the employee contributes. This option might be less expensive than the previous option, but it does not encourage employees to participate.
- For purposes of calculating the employer contribution, employee compensation is limited to $305,000.
- For self-employed individuals, their compensation is equal to 92.35% of net profit, which is on line 4a of schedule SE. This isn’t the same calculation as the SEP IRA contribution limit. That said, don’t take our word for it. Talk to your accountant before trying to do that calculation on your own. Remember, this is just the calculation for the employer contribution. Self-employed individuals are both the employer and the employee, so they can also contribute $14,000, assuming they pay themselves a high enough salary.
- Employer contributions are deductible by the employer.
- Employee contributions are deductible by the employee.
SIMPLE IRA Distribution Rules
The rule regarding SIMPLE IRA distributions are pretty similar to other types of IRAs. Generally speaking, you’ll want to wait until you’re 59.5 years old before making a withdrawal. Otherwise, you’ll have to pay a 10% penalty. There are exceptions to that, which you can read about here. However, as a rule of thumb, if you’re intending to use the account for retirement, you probably won’t want to withdraw the money prior to age 59.5 even if you do meet one of the exceptions.
There is one other unique characteristic of SIMPLE IRA distributions. If you withdraw money from the SIMPLE IRA — or even transfer the SIMPLE IRA into another retirement account like a Traditional IRA — within two years of when you first participated in the SIMPLE IRA plan, you have to pay a 25% penalty. Ouch! Generally what that means is that if you had a SIMPLE IRA for less than two years and you want to consolidate it into another retirement account, you’ll just need to wait until that two years have passed before consolidating. If you’re 59.5 years old or if one of these exceptions exists, then that penalty doesn’t apply.
What are the Pros and Cons of SIMPLE IRAs?
With the rules out of the way, let’s get down to business. What are the various pros and cons of SIMPLE IRAs? Why might someone choose to establish a SIMPLE IRA compared to a different type of retirement account?
SIMPLE IRA Pros
SIMPLE IRAs are pretty easy to administer relative to other group plans like a 401(k). There are no filing requirements (similar to a SEP IRA). And most financial institutions that offer retirement accounts will offer SIMPLE IRAs. If you want a plan that allows employees to participate, a SIMPLE IRA will, whereas a SEP IRA won’t. When you have employee participants who aren’t owners, a SIMPLE IRA is easier to administer than a 401(k). It’s also generally less expensive.
SIMPLE IRA Cons
SIMPLE IRAs are not all that flexible. As the employer, you must contribute either 2% or 3% (based on the options mentioned above) to employee accounts, even if you have a terrible year as a business. On the contrary, a SEP IRA allows you to choose to not contribute in certain years. They’re also not flexible because of the two-year rule I mentioned earlier. That rule imposes a hefty 25% penalty if funds are withdrawn or rolled over within the first two years.
For the self-employed person who wants to keep costs down, and isn’t necessarily looking for a plan that provides a benefit to employees, that required employer contribution isn’t appealing. Further, employees are more eligible to participate in a SIMPLE IRA sooner than they are a SEP IRA. A SIMPLE IRA must be offered to employees who have compensation of at least $5,000 in either of the prior two years and who are expected to earn at least $5,000 from your business this year. For a SEP IRA, that eligibility requirement is more stringent: employees must be age 21 or older, have worked in three of the past five years, and earn at least $650 from your business in this year.
If you don’t have employees, you might be thinking, “Hey, the contribution limits seem higher than a SEP IRA as long as I pay myself a normal salary. And I don’t have to deal with all of the complications of contributing to any employee accounts except my own. Sounds great!” That’s true. But we haven’t yet talked about a Solo 401(k), which is also referred to as a Single (k) or Individual (k). Those are generally just as easy to administer as SIMPLE IRAs. And they have higher contribution limits, along with other appealing benefits not available with SIMPLE IRAs. So stay tuned. In the meantime, contact us if you want to talk through your options or are interested in having us help with other financial planning or investment decisions.