Rules on Opening a Simple IRA for Your Small Business

Small business owners have many options when it comes to setting up a retirement plan for their business and employees.  Previously, I had mentioned the SEP IRA as one of the more common choices.  Another option is the the SIMPLE IRA.   But don’t let the name fool you.   When it comes to the rules of the SIMPLE IRA, I actually think it’s one of the most confusing when compared to the rest of the retirement plan options.

SIMPLE IRA stands for Savings Investment Match Plan for Employees.  Often times I’ll refer to it as the “mini-401k” as it’s traditional used for employers with less than a 100 employees.  In addition to that, the administrative cost of a SIMPLE IRA for your employer is considerably much less than what a 401(k) would be.

If you are a business owner, here are some consideration if your interested in opening a Simple IRA for you and your employees.

What You Give to Your Employees is Theirs-Immediately

In 401k plans, you are allowed to put a vesting schedule that requires the employee to work there for a certain number of years before they can take the money if they quit or get fired.   This is not the case with the Simple IRA.  The day that you make a contribution to your employee’s account, the money is immediately theirs.  If they want to cash it out, then they can; although they have to pay a pretty stiff penalty.

Employers Have To Match in a SIMPLE IRA

Each year, the you are required to  make a contribution to your SIMPLE IRA account whether it be in the form of a match or what’s called a non-elected contribution.  Matching contribution states that the employer has to match at least what you match.  So, if you’re matching 3%, the employer has to match 3% as well.  Note that 3% is the most that the employer has to match, which could be considerably different than compared to a 401(k) or SEP IRA.

You do have the option to reduce the matching amount to 1% for two of a five year period.  That means if you do decide to do this,  that you have to match the full 3% for the remaining three of those five years. This aspect makes the Simple IRA a little tricky and not quite that “simple”.

If you don’t want to worry about the match, then you can elect to do a non-elective contribution.  This means that you will have to contribute 2% of your employee’s salary no matter what.

Remember, what you match is based on the employee’s salary, not yours or the businesses.   Business owners often times get this confused.

The Employees Control the Investments

With most 401(k)s, you are limited to the investment options of the 401k provider.  This is considerably different when compared to the SIMPLE IRA.  Being a self employed retirement plan, the SIMPLE IRA gives you the discretion of what exactly you want your money  invested into.  If you want to buy 100 shares of XYZ stock, then you have the capability and freedom to do so.  (Note: you are allowed to do this in a SEP IRA, too)

Employees Can Defer, Too.

Employees, if they choose, can defer up to $11,500 per year into the Simple IRA.  You are currently allowed to contribute up to $11,500 per year in a SIMPLE IRA.  If  they are over the age of 50, then they are allowed a catch-up contribution, which is $2,500.  These are the same contribution limits as the business owner, as well.  Please note that the $11,500 is far less than the $16,500 that you are eligible to contribute to a 401k.

No Borrowing Allowed

Simple IRA’s do not allow you to borrow as a 401k plan may.  If they have to get money, they’ll have to pay tax and penalty, which is higher than most plans-see below.

The SIMPLE IRA Two-year Rule.

This is something that should be definitely noted within the SIMPLE IRA.  Most retirement plans — 401(k)s, regular IRAs, or Roth IRAs, etc. — have the 10% early withdrawal penalty if under the age of 59.5.  But with the SIMPLE IRA, it takes it one step further.  If the SIMPLE IRA that you’ve started is less than two years and you cash that out, instead of the normal 10% penalty, you will be subject to a 25% penalty in addition to ordinary income tax.  That is a huge item to not be overlooked.  Keeping in mind as well too that doesn’t apply to just cashing it out.  If you were attempting to roll over your SIMPLE IRA into a rollover IRA, the 25% penalty would apply as well.  The key point is just to wait the two years before converting into either a regular IRA or cashing it out.

 

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