SIMPLE IRA: What it is and how it works

If you work for a small business, you have a retirement savings option that some people don’t: a savings incentive match plan for employees (SIMPLE IRA). A SIMPLE IRA has advantages for small employers. For one, it can be a less complex plan to offer. And potential benefits to employees include tax advantages, employer contributions and immediate vesting. 

How does a SIMPLE IRA work? What are its pros and cons? And how does it compare to other retirement accounts? 

Key takeaways

• SIMPLE IRAs belong to the family of individual retirement accounts (IRAs). They have similarities and differences to traditional IRAs and Roth IRAs.
• Employees aren’t required to contribute to their SIMPLE IRAs. But their employers are, in the form of matching contributions or nonelective contributions. 
• Because a SIMPLE IRA plan is tax deferred, the employee doesn’t pay taxes on the money in their account until they withdraw it.
• 401(k) plans and simplified employee pension (SEP) IRAs are other types of retirement plans employers might offer.

A SIMPLE IRA is a retirement plan that’s offered through small businesses to their employees. An employee can choose to contribute a portion of their pay to their account with the goal of allowing it to grow over time. Because a SIMPLE IRA plan is tax deferred, the employee doesn’t pay taxes on the money in their account until they withdraw it in the future. 

Employees aren’t required to contribute to their SIMPLE IRAs but their employers are. Employers can either make a matching contribution or a nonelective contribution. You’ll learn more about both later in this article.

SIMPLE IRAs belong to the larger group of IRAs. Here are some details on how they compare to traditional IRAs and Roth IRAs:

Is a SIMPLE IRA the same as a traditional IRA?

Here’s how SIMPLE and traditional IRAs compare:

• Eligibility: SIMPLE IRAs are provided through small employers but traditional IRAs are set up by individuals. That means people with traditional IRAs don’t benefit from employer-made contributions like those with SIMPLE IRAs do. 
• Tax advantages: Both IRAs allow the account owner to defer paying taxes on the money they’ve contributed until it’s withdrawn from the account. The same is true for money the account earns.
• Contribution limits: Contribution limits are typically higher for SIMPLE IRAs than for traditional IRAs.

Is a SIMPLE IRA the same as a Roth IRA?

Here’s how SIMPLE and Roth IRAs compare:

• Eligibility: Only employees of small businesses can have a SIMPLE IRA. But most people can have a Roth IRA. 
• Tax advantages: SIMPLE IRA contributions are made with pre-tax money that’s not taxed until withdrawals are made from the account. Roth IRA contributions are made with after-tax dollars, which means withdrawals generally aren’t taxed. The same is true for money the account earns.
• Contribution limits: Contribution limits are typically higher for SIMPLE IRAs than for Roth IRAs.

Most small businesses can offer a SIMPLE IRA plan if they meet certain requirements—for example, having 100 or fewer employees during the previous calendar year. And most employees are eligible to participate in a SIMPLE IRA plan.

Employees can decide on a year-to-year basis whether or not to contribute to their SIMPLE IRA. Employers, on the other hand, are required to contribute to the SIMPLE IRAs of their employees. 

According to the IRS, employers must choose one of these contribution methods each year:

• 3% matching contribution: Employers can match an employee’s contributions dollar for dollar up to 3% of the employee’s compensation.  
• 2% nonelective contribution: Even if an employee doesn’t contribute to their plan, the employer is required to contribute an amount equal to 2% of their compensation up to an annual limit. For 2023, that limit is $330,000. 

Contributions made to a SIMPLE IRA can be invested in a number of ways, including mutual funds, individual stocks and other types of investments. The employee decides how to invest the contributions in their account.

SIMPLE IRA eligibility rules

Employees are generally eligible for a SIMPLE IRA through their company if they: 

• earned at least $5,000 during any 2 years prior to the current calendar year
• expect to earn at least $5,000 in the current calendar year

The IRA allows employers to ease these restrictions if they choose to. 

In some situations, employees can be excluded from participating. This can include resident aliens of the U.S. as well as employees who are covered by certain collective bargaining agreements. 

SIMPLE IRA withdrawal rules

Typically, an employee can withdraw money from their SIMPLE IRA at any time. Withdrawing is known as taking a distribution. The employer isn’t allowed to impose restrictions on withdrawals.

You’ll usually owe income tax on any money you take from your SIMPLE IRA. Plus, you may owe an early-withdrawal penalty if you take the money before you’re 59 ½ years old. The penalty is either 10% or 25% of the withdrawal amount, based on how long you’ve participated in the plan. There are other exceptions to the early-withdrawal penalty, including for disabled people.

According to the IRS, contributions from an employee under 50 to their SIMPLE IRA can’t exceed $15,500 in 2023. If they participate in other employer retirement plans and make contributions, the total amount of their 2023 contributions can’t be more than $22,500. 

People who are 50 or older at the end of the calendar year may be able to make catch-up contributions. This means they could contribute an additional $3,500 to their SIMPLE IRA in 2023 for a total contribution of $19,000.

Are SIMPLE IRA contributions pre-tax?

Yes, the SIMPLE IRA contributions made by an employee are pre-tax. That means the contributions aren’t subject to federal income tax withholding. But the IRS notes that they are subject to Medicare, Social Security and Employer’s Annual Federal Unemployment (FUTA) taxes.

If you’re considering participating in your company’s SIMPLE IRA plan, it may help to know more about its benefits and drawbacks.

Benefits

Major benefits of a SIMPLE IRA can include:

• Tax-deferred savings: An employee can contribute pre-tax dollars to their SIMPLE IRA. They pay taxes on the money once they withdraw it.
• Immediate vesting: With a SIMPLE IRA, an employee is fully vested right away. That means the employer contributions to their account belong to them no matter how long they’ve been with the company.
• Tax-deductible contributions: Money put into a SIMPLE IRA is tax deductible for both employees and employers.

Drawbacks

Key disadvantages of a SIMPLE IRA can include:

• Lower contribution limits: Contribution limits can be lower compared to other retirement plans. For example, the contribution limits for 401(k) retirement plans are typically higher. 
• Penalties for early withdrawal: If a SIMPLE IRA participant makes a withdrawal before age 59½, they’re assessed with a 10% additional tax. If this withdrawal happens in the first 2 years of participation in the plan, the 10% tax is increased to a 25% tax.

You’ve already read about how SIMPLE IRAs compare to traditional IRAs and Roth IRAs. Now, learn more about how they stack up against 2 other popular retirement investment plans. 

401(k)s

Like a SIMPLE IRA, a 401(k) savings plan is designed to set aside earnings for retirement. While both are offered through employers, the SIMPLE IRA is specifically for small-business employers.

With a 401(k), an employee makes contributions to their account and the employer may match some of the contribution, or all of it. The employee is allowed to choose where to invest their money among options that include mutual funds.

There are 2 primary types of 401(k) accounts: the traditional 401(k) plan and the Roth 401(k). Like a SIMPLE IRA, they can both offer tax advantages to the employee.

Contribution limits tend to be higher for 401(k) accounts than for SIMPLE IRAs.

SEP IRAs

SIMPLE IRAs and SEP IRAs were created for the same reason: to help businesses offer their employees a way to save for retirement. 

Both plans offer tax advantages to the employee account holder. One major difference is that a SIMPLE IRA allows both employees and employers to contribute but a SEP IRA allows contributions only from the employer. 

For 2023, the IRS has established a contribution limit for SEP IRAs of 25% of an employee’s salary or a maximum of $66,000, whichever amount is less. For SIMPLE IRAs, the maximum an employee can contribute from their salary in 2023 is $15,500, plus a catch-up limit of $3,500.

SIMPLE IRAs are retirement savings accounts that help small businesses offer their employees a retirement savings plan. SIMPLE IRAs have advantages for small businesses, one of which is that they’re relatively easy to administer. Benefits to employees include tax advantages, employer-made contributions and immediate vesting no matter how long the employee’s been with the company. 

While you’re thinking about retirement savings, you may want to learn more about the variety of IRAs available to individual investors and through employers. And if you’re unsure how much to set aside for retirement, you can learn more about how much money is needed to retire.