Funding a retirement savings plan for employees is a challenge for businesses of all sizes, but the challenge is exacerbated for small businesses with less operating capital and fewer resources. With this challenge in mind, the IRS created the SIMPLE retirement savings plans for small businesses—businesses with fewer than one hundred employees—to meet the needs of their workers. This necessarily created the complex SIMPLE IRA vs 401k choice.
As we will demonstrate in this article, each plan has its advantages and neither plan can be considered without taking the needs of both the company and its employees into consideration. Generally, with the SIMPLE IRA vs 401k debate, the IRA option is stronger for individuals and businesses that may need a measure of flexibility, whereas the 401k option does more to promote a sense of continuity for all parties involved. The reasons behind this dichotomy are described succinctly below.
What Is a Retirement Savings Plan?
There are a wide variety of retirement savings plans on the market, but they all share a few key features. A retirement savings plan takes the capital you have available to put away for retirement and invests it to create more capital than one could expect from interest on money that sat in a savings account. Investment vehicles for retirement invariably become more conservative as you approach retirement age.
For example, if you were 30 years old, and you decided to put 3% of your annual salary toward retirement, a retirement savings plan would invest that capital in stocks and bonds that yielded more than the interest rate offered by your bank. As you age, the plan would move your assets from investment in companies with the potential to fluctuate in value to more stable, lower-yield assets like government bonds.
Almost every small company offers either a SIMPLE 401k or a SIMPLE IRA. If your employer does not offer a retirement plan, it is probably because they are a small business without the capital to set a retirement plan for their employees. In this case, you should set up an IRA account for yourself as there is not an option to set up a 401k for yourself.
Is a SIMPLE IRA Different from a SIMPLE 401k?
Yes, but before we delineate the difference between the two types of accounts, we will briefly explain the similarities. Both types of accounts take the capital you put toward retirement and invest it to ensure your nest egg grows throughout your working life. The most appealing feature of both is that the funds you invest are tax-deferred, meaning you do not pay taxes on the segment of income you invest until you receive disbursements in retirement.
For our purposes in this article, it is important to note the difference between SIMPLE and traditional retirement accounts. SIMPLE (Savings Incentive Match Plan for Employees of Small Employers) plans are easier to administer and come with lower contribution limits for both the employee and the employer, whereas traditional accounts have higher contribution limits and must be analyzed annually to ensure tax incentives remain appropriate in the eyes of the IRS.
Why Would an Employer Choose a SIMPLE Plan?
The IRS created SIMPLE plans as an option for smaller employers without the capital to set up costly traditional plans nor meet the exorbitant contribution limits that larger companies stomach for the sake of their upper echelon of talent. SIMPLE plans are also a strong retirement option for self-employed individuals or individuals who run a business on their own.
To create a SIMPLE plan, a company must employ fewer than one hundred employees who make more than $5000 every year. If an employer offers its employees a SIMPLE plan, they cannot concurrently offer any other type of plan with the exception of employers subject to the dictates of highly idiosyncratic collective bargaining agreements.
SIMPLE IRA vs 401k | The Difference
Despite these broad similarities between the two types of accounts, the differences are myriad and worth your consideration as you weigh the pros and cons of the SIMPLE IRA vs 401k. The most important differences are described below.
In both types of accounts, contributions are made tax-free. The IRS does not consider the money you elect to contribute to your retirement account as a portion of your taxable income; however, when you retire and begin to receive disbursements from your retirement account, that will constitute taxable income in the eyes of the IRS. The only way to avoid paying taxes on disbursements in retirement is to set up a Roth IRA.
Regarding our consideration of the taxation of a SIMPLE IRA vs 401k, the most important difference is that contributions to an IRA account are tax deductible in the year you make the contributions.
To be eligible to participate in your company's SIMPLE 401k plan, you must have worked for the company for at least one year and have reached the age of 21. So, if an 18-year-old began working at a small company that offered a SIMPLE 401k immediately upon completing high school, they could not contribute to their retirement funds for the first three years of their time with our hypothetical employer.
Conversely, in a SIMPLE IRA, there are no restrictions of that kind. Therefore, our same hypothetical 18-year-old high school graduate could make employer matched contribution to a SIMPLE IRA immediately, or he or she could elect to be self-employed and set up a SIMPLE IRA for him or herself at any point.
As you consider a SIMPLE IRA vs 401k, keep in mind that the requirements of the 401k are more onerous, but that most employees bypass the requirements early in their careers, before they even begin thinking about the accrual of retirement capital.
Contribution Limits and Employer Match
Unfortunately, the most consequential difference in a consideration of the SIMPLE IRA vs 401k is often out of your hands, as your employer will offer one or the other, but not both. In either case, your employer will match your contribution to a certain point up to 3%. However, there are more regulations on contributions to a 401k, especially for higher earners; therefore, to maximize employer contributions, a SIMPLE 401k is more desirable than the IRA option.
In a SIMPLE 401k, the employer must match the employee's contributions up to 3% of the employee's annual compensation on an elective basis or make an annual contribution of 2% of the employee's annual compensation on a non-elective basis. This means the employer can match the employee's contributions or pay 2% every year, regardless of what the employee contributes.
For example, if employee X makes 100,000 dollars every year, under a SIMPLE 401k, the employer can choose to either contribute whatever employee X contributes up to $3,000, or $2,000 every year regardless of whether employee X contributes 3% or 1%.
In a SIMPLE IRA, the employer can choose which percentage they will match up to 3%; however, the employer must match at least 1% of the employee's annual compensation. This scheme provides small employers with minimal capital a flexible way to offer employees a retirement plan.
A Note on High Earners
For businesses and individuals using the 401k plan, it should be noted that, as of 2019, the IRS restricts the maximum salary from being considered to $280,000, with regard to the 3% employer contribution. So, if someone made $300,000 and elected to contribute 3% of their salary, their employer could not match the contribution entirely; the employer would only contribute 3% of $280,000.
One of the most important considerations in SIMPLE IRA vs 401k is the investment options offered by both types of accounts, which must be done regarding the priorities of the employees who would be investing in either type of account.
Because the companies that offer retirement savings accounts rarely operate the accounts themselves, especially smaller companies, management of the accounts is generally outsourced to an investment bank that deals in retirement products such as Fidelity or Vanguard. In the case of the SIMPLE 401k, the types of investment options with these investment banks are often limited to pre-packaged products such as target-date funds.
A target-date fund is a retirement savings product wherein an employee chooses a date at which they would like to stop working, and the investment company sets incremental goals pertaining to contributions and investment income that will theoretically lead to the accrual of sufficient capital to stop working by the date in question. These types of investment products often come with managerial fees that the employee has no way to avoid as this is what is offered in his or her 401k, and that is that.
With a SIMPLE IRA, there are few restrictions on which types of investment products you can use to build long-term wealth. This often means that employees with a SIMPLE IRA can choose profitable investment products with lower fees and thereby maximize the capital they choose to put towards their retirement without being subject to the restrictions of an employer's pre-determined plan.
As we have researched and analyzed the key points of the SIMPLE IRA vs 401k debate, we have found merits to both plans that highly depend on the priorities of both the employee and the employer.
The SIMPLE 401k is a strong option for both employees and employers who prize continuity and predictability. From the employer's perspective, the year-long waiting period for inclusion and the consistency of contributions annually provide a strong incentive for employees to stay with the company in the long-term. From the employee's perspective, the 401k maximizes employer contributions year after year, but it also minimizes the employee's role in selecting their own investment products.
In terms of flexibility for both the employee and the employer, the IRA is the clear winner of the SIMPLE IRA vs 401k contest. As an employee using a SIMPLE IRA, you can choose more precisely how your retirement capital is invested, and you have more options to leverage your capital without being undermined by administrative fees and specific investment products. For small businesses, the SIMPLE IRA allows for wiggle room in terms of annual contributions. This can be crucial for young businesses or businesses with high overhead costs.