By T.J. Porter, WCI Contributor
Everyone needs to have a plan for their retirement, because without a plan, you might find yourself wanting to retire but without the necessary resources to pay the bills once you quit your job. The good news is that planning for retirement, at its most basic, is simple. Spend less than you make, and set aside your extra cash. When you’re ready to retire, use that savings to pay your bills. Perhaps a SIMPLE IRA plan would be one way to help you start saving for retirement.
Of course, proper retirement planning will make your money go much further, helping you have a better retirement. Understanding the different accounts and tools available to you can help you save for retirement in the most effective way. Is a SIMPLE IRA one way to help you save for your post-work life? Here's what you need to know.
What Is a SIMPLE IRA?
A Savings Incentive Match Plan for Employees (SIMPLE) IRA is a type of retirement account that employers can offer to employees as a benefit. If you have people that work for your business, you can give them SIMPLE IRAs to help them save for the future.
Employees can choose to save some of their income in their SIMPLE IRA. Employers can also make contributions on employees’ behalf. In fact, the IRS requires employers to make contributions for their employees by either matching the employee contributions up to 3% of their salary or by simply contributing a 2% flat rate of each employee’s salary.
How Does a SIMPLE IRA Work?
SIMPLE IRAs are designed for small businesses. Generally, a business must have 100 or fewer employees to be eligible.
Like other retirement accounts, SIMPLE IRAs offer tax incentives to the people who use them to save for retirement. Employees contribute money on a pre-tax basis, meaning they do not pay income tax on the money contributed. Instead, they pay taxes when they withdraw the money in their retirement.
Employers also get a benefit for offering SIMPLE IRAs. The company may deduct contributions it makes to its employees’ IRAs from its income, reducing its own tax liability. This is true even for sole proprietors making employer contributions into their own accounts.
SIMPLE IRAs otherwise work like most other pre-tax retirement accounts. People typically can’t withdraw money from their IRA until they turn 59 ½ without paying a penalty. Early withdrawals incur a 10% penalty in addition to any tax the withdrawal would typically owe.
SIMPLE IRA Contribution Limits
Like other retirement accounts, the amount an employee can contribute to their SIMPLE IRA is limited. In 2022, the limit is $14,000 ($13,500 in 2021). The IRS revises this limit each year based on inflation.
Employees who are 50 or older may make additional catch-up contributions of up to $3,000.
Employers may offer matching contributions on up to 3% of the employee’s salary. Alternatively, they may contribute 2% of each employee’s salary on each employee’s behalf. Employers must offer either matching or automatic contributions.
Employer funding of SIMPLE IRAs (whether the employer matches contributions of up to 3% of the employee's salary or whether the employer contributes 2% of the employee's salary) does not count toward the employee’s $14,000 contribution limit.
Pros and Cons of SIMPLE IRA Plans
Pros
- Easy to Set Up: As the name suggests, SIMPLE IRAs are one of the easier and less expensive types of retirement accounts to set up. This makes them ideal for small businesses and startups.
- Wide Choice of Investments: You can put almost any paper asset into a SIMPLE IRA. Most SIMPLE IRA providers will give you a limited list of mutual funds to choose from but you can look for a more flexible provider if needed.
Cons
- Lower Contribution Limit: SIMPLE IRAs have a lower contribution limit than 401(k) plans ($20,500 for 2022), so they aren’t as powerful when used as a tax shelter.
- Less Flexibility: SIMPLE IRAs don’t permit loans like 401(k)s do. They also count as IRAs which can affect your ability to use strategies like Backdoor Roth IRA rollovers in the future.
- No Roth Option: You can only contribute to a SIMPLE IRA on a pre-tax basis. There is no Roth option like there is for individual IRAs or 401(k)s.
Do You Pay Taxes on a SIMPLE IRA?
One of the main reasons that people use retirement accounts to save for retirement is the tax incentive they provide.
With a SIMPLE IRA, you will have to pay taxes but not immediately. Employees deduct any money they contribute to an IRA from their income when filing their taxes. For example, someone who earned $50,000 and contributed $5,000 to their SIMPLE IRA would report their income as $45,000.
That means they can avoid paying income tax on the $5,000 they contributed for the time being.
Similarly, the employer offering the SIMPLE IRA deducts the contributions it makes on employees’ behalfs as a business expense.
The taxes come when people withdraw money from their SIMPLE IRA. Any money withdrawn is treated as normal income and reported as such on your income taxes. If you made $20,000 in a year and withdrew $10,000 from your SIMPLE IRA, you’ll have to report $30,000 in income when filing your taxes.
The benefit of this tax deferral is that retirees, especially physicians and other high-income earners, typically have lower incomes than they did when they were still working. That lower income places them in a lower tax bracket so their withdrawals are taxed at a lower rate than their contributions would have been during their peak earning years.
How to Open a SIMPLE IRA
Opening a SIMPLE IRA involves three steps:
- Put together a written agreement for your business to offer a SIMPLE IRA to all employees
- Give employees information about that agreement
- Set up an account for each employee
The SIMPLE IRA provider that you choose can help you with all of these steps. Many major investment companies offer SIMPLE IRA services. If you already have a brokerage account, there’s a good chance you can work with the same business to manage your SIMPLE IRA.
SIMPLE IRA Distributions and Withdrawals
SIMPLE IRAs, like other retirement accounts, restrict withdrawals until you reach retirement age. You are not allowed to withdraw money from the account until you turn 59 ½.
If you do make an early withdrawal, you’ll pay a 10% penalty on top of the taxes you would owe. Withdrawals are treated as normal income for the year in which they’re made, so you’ll pay income tax on any money you take out of the account.
SIMPLE IRAs also have Required Minimum Distributions (RMDs) beginning in the year you turn 72.
Who Is Eligible for a SIMPLE IRA?
Individuals cannot open a SIMPLE IRA. They have to be opened by a business, whether that business is a partnership, LLC, sole proprietorship, or otherwise.
That means you can’t open a SIMPLE IRA for yourself unless you have your own business. However, if you do have your own business, there’s nothing stopping you from opening a SIMPLE IRA and making contributions as both an employee and an employer.
SIMPLE IRA vs. SEP IRA
If you’re considering a SIMPLE IRA, you may also be interested in opening a Simplified Employee Pension (SEP) IRA. Both accounts let employers offer retirement benefits to employees, but they have significant differences to be aware of.
Conclusion
If you have your own business, a SIMPLE IRA is one option for increasing your retirement savings or giving your employees a way to save for the future. However, SIMPLE IRAs are generally less flexible and offer less potential savings than other retirement plans, like 401(k)s and SEP IRAs.
If you're a doctor, a SIMPLE IRA is probably not your best bet (the docs who tend to use these plans are some dentists and small-practice owners with employees). If you're potentially interested in that type of plan, though, you should commission a study on your practice to determine whether a 401(k), a SEP IRA, a SIMPLE IRA, or nothing at all is the right plan for the employees in your practice.
If you need extra help with planning for retirement or have questions about the best way to save your money in tax-protected accounts, hire a WCI-vetted professional to help you figure it out.
The White Coat Investor is filled with posts like this, whether it’s increasing your financial literacy, showing you the best strategies on your path to financial success, or discussing the topic of mental wellness. To discover just how much The White Coat Investor can help you in your financial journey, start here to read some of our most popular posts and to see everything else WCI has to offer. And make sure to sign up for our newsletters to keep up with our newest content.
For 2021, I did a back door Roth conversion of $6000 (max) in May 2021.
In Nov 2021 I became eligible for a SIMPLE IRA. I maxed that out ($13,500).
My CPA says the two contributions are cumulative and I have to remove the $6000 to not get penalized.
I’m pretty sure I’m correct in my contributions because the the SIMPLE IRA is classified as a workplace retirement plan. Making the two contributions independent of each other.
Any proof and possible IRS link to show my CPA would be helpful.
Thanks!!
That’s not true. However, your conversion will be pro-rated. That’s the bigger problem here. The Backdoor Roth IRA process and using a SIMPLE IRA aren’t really very compatible.
https://www.whitecoatinvestor.com/multiple-401k-rules/
https://www.whitecoatinvestor.com/backdoor-roth-ira-tutorial/
Thanks for your comment Jim!
From your comment, I gather that the IRS doesn’t look at the date of the contribution for a particular year. They look at the calendar year as a whole to determine if the backdoor conversion will be pro-rated. So though I thought I was being creative by timing my contributions/conversions, the IRS says, “No, no no!”?
How I thought I was being sneaky:
early-May 2021: tIRA: $6000, rIRA: x, SIMPLE IRA: $0
late-May 2021: tIRA: $0, rIRA: x+$6000, SIMPLE IRA: $0
November 2021: tIRA: $0, rIRA: x+$6000, SIMPLE IRA: $13,500
So now that I have mucked things up, which of your blog posts helps me undo this?
There isn’t one. This is one that can’t be fixed in any easy way. You just get pro-rated and if you keep doing Roth conversions, you get pro-rated some more. A SIMPLE IRA and a Backdoor Roth IRA process really aren’t very compatible. Pick one or the other. Most pick the SIMPLE IRA since the contribution limit is higher. You could do a non-deductible IRA contribution in hopes that some time you’ll figure out a way to convert it in the future, but I wouldn’t do any more conversions.
Agreed. No more backdoors for me.
Current CPA said dealing with this is out of her scope and referred me to another CPA 🙁 I have an appointment with the other firm in a couple weeks (current one filed an extension).
In addition to being pro-rated, I need to figure out if I over contributed. Would you or someone like to comment if it was okay to contributed $6000 to tIRA + $13,500 to the SIMPLE IRA? Or if the max aggregate is $13,500.
If the max is $13,500, I need to remove $6,000 from the SIMPLE for 2021. If not, I’ll be penalized 6% until I do, correct? IRS link: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits
The contribution is fine. The limits are separate.
What if you already have a Roth IRA in place from doing the Backdoor Roth in years past, and your new employer has a SIMPLE IRA instead of a 401k? Can you leave the Roth IRA in place and just not do the Backdoor Roth in the years moving forward (the years you use the SIMPLE IRA)?
Yes.
You could also do the first step (contribution) and just not do the second step if you want. You could do that later and just pay taxes on the conversion of any earnings on that money.