A Savings Incentive Match Plan for Employees, or SIMPLE, IRA is a type of retirement plan designed for small businesses. Your employer must set it up for you, and you can't set it up for yourself unless you're self-employed. A traditional individual retirement arrangement is an account you set up for yourself with a brokerage or bank.
A SIMPLE IRA is an employer-sponsored plan that must include employer contributions as well as employee-contributed funds, while a traditional IRA is something you set up for yourself. Both allow you to defer taxes on contributed earnings until you withdraw them, usually for retirement.
SIMPLE IRA Tax Advantages
As the name suggests, a SIMPLE IRA is designed to be a simple choice for small businesses. Generally, companies with up to 100 employees can use SIMPLE IRAs as their retirement plans, as can sole proprietors who are self-employed. It's not mandatory to participate in a SIMPLE IRA if your employer offers one.
Employers must either contribute an amount equal to 2 percent of the first $275,000 of each employee's annual salary or match contributions up to the limit of between 1 and 3 percent of employee salaries. Employees can also contribute to their own accounts as they see fit up to a $12,500 annual limit.
The contributed funds aren't subject to tax as income until they're withdrawn. This lets employees defer taxes until they retire, at which time they are often in a lower tax bracket. If you withdraw funds from a SIMPLE IRA before you are 59 ½, it is usually subject to an additional 10 percent tax penalty or 25 percent if it's within the first two years of the account's existence.
Traditional IRAs and Their Benefits
You can set up a traditional IRA for yourself at a bank or brokerage of your choice. You can even have more than one if you wish. Each year, you can contribute up to $5,500 to your traditional IRA accounts or up to $6,500 if you're age 50 or older. That contribution is deductible from your taxes, and you can generally make it at any point up to your annual tax filing deadline for a tax year, even if it's into the next calendar year.
When you withdraw money from your traditional IRA, it is taxed similar to a SIMPLE IRA. If you withdraw before age 59 ½, you must pay an additional 10 percent tax penalty unless certain exceptions apply. Traditional and SIMPLE IRAs both serve similar goals of incentivizing savings by allowing you to avoid taxes until you retire.
SEP IRA vs. SIMPLE IRA
Another option for small businesses considering retirement plans is the Simplified Employee Pension IRA, or SEP IRA. It involves only employer contributions, not any from employees. Employers contribute a value equivalent to a particular percentage of each employee's income, which must be the same for each employee but may differ from year to year. Only the first $275,000 of compensation is considered, and the percentage must be no larger than 25 percent. The varying percentage allows employers to share more profit with employees when doing well and to cut back when times are more tough.
The employee isn't taxed on the money in the SEP IRA account until it's withdrawn. As with traditional IRAs, employees can withdraw before they turn 59 ½, but they will face an additional 10 percent tax penalty.
SIMPLE IRA Rollover
If you have a SIMPLE IRA and leave your employer, you can roll the funds into a new SIMPLE IRA without any tax penalty. After two years from when you begin participating in a SIMPLE IRA, you can roll your funds over to a new traditional IRA if you wish. You can also roll SEP IRAs into traditional IRAs if you choose to do so. You might do so to consolidate your funds with one provider or take advantage of better investment opportunities or pricing available from one brokerage or another.
You can generally roll funds from one IRA to another without a tax penalty, provided you file the right legal procedures. It's generally best to have one financial institution send the money directly to the other. Otherwise, you can face tax withholding of 20 percent and an additional tax penalty if the money isn't deposited at the new institution within 60 days.
Often, but not always, you must liquidate your holdings in the old account to transfer them to the new one, especially if the old account contains funds or other investments not supported at your new institution. Check with the financial institutions involved to learn what's possible and what forms to fill out to initiate a rollover.
IRA Early Withdrawal Rules
The rules around withdrawals from SEP, SIMPLE and traditional IRAs are all the same. If you are under 59 ½ and you take money out, you must pay taxes and the 10 percent penalty unless certain exceptions apply. Then, you only pay the taxes on the money as income and not a penalty.
Exemptions apply if you are part of the military reserves or National Guard and you're called for active duty. You can also take an exemption from the penalty if you withdraw up to $10,000 for the purchase of your first home. If you are unemployed and need to buy medical insurance, you can use IRA funds to do so with no penalty. Similarly, you can pay medical expenses that exceed 7.5 percent of your adjusted gross income without penalty.
Certain educational expenses can also be paid with IRA funds without a penalty. These rules don't all apply to non-IRA types of employee retirement plans, like 401(k) and 403(b) plans, though you can sometimes roll over these plans to a traditional IRA once you leave your employer. Consult the IRS or a tax adviser for details if you think an exception may apply to your needs.
Roth IRA Plans
Another type of IRA is the Roth IRA. Unlike traditional, SEP and SIMPLE IRAs, you must pay taxes as normal on money you put into a Roth IRA. When you withdraw funds for retirement, including any investment earnings, you do not owe federal tax.
Roth IRAs can be advantageous if you anticipate being in a high tax bracket when you retire or having high investment earnings before you get to retirement age. If you make too much money, you may not be eligible to put money into a Roth IRA. Otherwise, Roth IRA contributions and traditional IRA contributions count together toward the $5,500 annual limit or $6,500 limit if you're over 50.
SIMPLE and SEP IRAs follow their own rules, as do other employer-sponsored plans. Still, if you are offered a SIMPLE IRA at work or your employer has a SEP IRA, that may affect your decisions about how much to put into your traditional and Roth IRA accounts if you have them.
SEP and SIMPLE IRAs cannot be Roth IRAs, although there are Roth versions of other employer plans like 401(k) plans and the 403(b) plans used by some government agencies and nonprofits. You can convert a traditional IRA into a Roth IRA plan by going through a formal procedure and paying the deferred taxes on the funds you have in the account.
- Investopedia: SIMPLE IRAS: Introduction
- IRS: SIMPLE IRA Plan
- IRS: Publication 560 (2017), Retirement Plans for Small Business
- IRS: Simplified Employee Pension Plan (SEP)
- IRS: Operating a SEP
- IRS: Publication 590-B (2017), Distributions from Individual Retirement Arrangements (IRAs)
- IRS: Publication 590-A (2017), Contributions to Individual Retirement Arrangements (IRAs)