This retirement plan is less simple than the name implies

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Just about anyone who has been employed by a company has heard of retirement plans like a 401(k) or an individual retirement account (IRA). One you might not be so familiar with is a Savings Incentive Match Plan for Employees, or a SIMPLE IRA for short.

Here's everything you need to know about a SIMPLE IRA, from how it can help you achieve your retirement goals, to whether it's the right choice for you.

SIMPLE IRA Definition

A SIMPLE IRA is an employer-sponsored retirement plan offered within small businesses that have 100 or fewer employees. Small businesses may favor SIMPLE IRAs because they are a less expensive and complicated alternative to a 401(k) plan.

But some distinct rules apply to these accounts. Namely, with a SIMPLE IRA, the employer matching incentive is built into the plan. As such, the employer must either match the contributions employees make to their plan, up to 3% (but no less than 1%) of their salary, or make contributions for employees amounting to a flat 2% of their salary, whether or not the employee chooses to contribute to the plan.

SIMPLE IRA vs. 401(k)

This plan type differs from 401(k) plans. An employer offering a 401(k) plan can choose whether to match employee contributions. Many do, but in difficult economic times, matching programs can be among the first benefits to get cut. Employers who choose to offer SIMPLE IRAs are generally required to match, dollar for dollar, anywhere from 1%–3% of the employee's salary.

In other respects, a SIMPLE IRA works a lot like a 401(k) plan. Contributions to the plan are made pre-tax, and the money in the plan accumulates tax-deferred until the money is withdrawn at retirement. If the money is withdrawn before age 59.5, you will pay both ordinary income tax and a 10% penalty tax on it (25% if you withdraw it within two years of enrolling in the plan).

Within a SIMPLE IRA, your employer will likely offer a wide variety of stock and bond mutual funds. If you are a small business employer, the decision to offer a SIMPLE IRA vs a 401(k) is often not so much about the size of your company or the number of employees, but how much cost and effort you want to invest to maintain the plan. Typically, SIMPLE IRAs don't impose a filing requirement on the employer, and operating costs are lower than 401(k) and other traditional retirement plans.

Generally, if you withdraw the money in a SIMPLE IRA before you reach the age of 59.5, you'll have to pay income tax and a penalty tax of at least 10% (but as much as 25%) on it depending on how long you've been participating in the plan.

SIMPLE IRA Rules on Contributions 

The contribution limits for a SIMPLE IRA are different than the 401(k) contribution limits. In 2021, as in 2020, employees can contribute $13,500 to a SIMPLE IRA. The catch-up contribution limit is $3,000, making the SIMPLE IRA contribution limit $16,500 for participants age 50 or older.

With a 401(k), individuals can save $19,500 in 2021 or up to $26,000 with a catch-up contribution, which is unchanged from 2020. As you can see, you can sock away more in a 401(k) plan.

But if you have a SIMPLE IRA and you participate in any other type of employer retirement plan during the year—a 401(k), for example—the limit on how much you can contribute to all the plans is $19,500.

If you're a highly paid small business owner, such as a doctor, dentist, or attorney, you might favor a 401(k) plan over a SIMPLE IRA because of the higher contribution limits offered by the former.

Rollovers With SIMPLE IRAs

SIMPLE IRA rollovers can be simple or a hassle depending on how long you've been participating in the plan. If you've participated for less than two years, you can only roll funds from a SIMPLE IRA into another SIMPLE IRA. Otherwise, the amount will be considered a withdrawal, and you'll have to treat it as taxable income and pay a 25% tax on it (unless you're at least 59.5 or qualify for another exception).

But if two years have passed since you began to participate in the plan, you can move the money into most any type of IRA (but not a Roth IRA) or even an employer-sponsored retirement plan such as a 401(k).