With business growth and more full-time employees, small business owners might realize that they must offer competitive retirement plans to support their workers. Solo 401k and SEP IRA work well for self-employed entrepreneurs, but they become costly or unavailable as your business grows.  Thankfully, there are retirement plans designed for small business owners. These plans can help you keep the people you need most to grow your business empire.

The SIMPLE plans

A Savings Incentive Match Plan for Employees (SIMPLE) is a tax-deferred retirement plan available to businesses with 100 or fewer eligible employees. When employers set up a SIMPLE plan for their employees, they cannot provide other additional employer-sponsored retirement plans.

SIMPLE plans come in two different flavors: SIMPLE IRA and SIMPLE 401k. While they share many similarities, the differences are useful to you as a business owner. Each plan affects your bottom line differently and we will go over them in detail.

Eligible employees

Both SIMPLE IRA and SIMPLE 401k have the same definition of eligible employees. An eligible employee is someone who has received at least $5,000 from your company in compensation in any of the past two years. Additionally, this employee expects to receive at least $5,000 this year. The SIMPLE plan must cover any employee meeting this standard.

While employers can lower the requirement to be more inclusive, they must cover all eligible employees without exception.

SIMPLE IRA

A SIMPLE IRA is a traditional IRA account that both the employer and the employee can contribute to. The employees contribute to their SIMPLE IRAs with pre-tax income and the investments can grow tax-deferred. The contributions come directly out of their monthly paychecks before-tax.  When the employees retire, they will pay ordinary income tax on the withdrawal based on their tax bracket.

Contribution

Contribution to a SIMPLE IRA account has two parts: employee contribution and employer contribution. While employee contribution is optional, the employer must always contribute to the plan.

Employee contribution

Under a SIMPLE IRA plan, the employee can contribute up to $13,500 a year in 2020. Any contribution will reduce the employee’s total limit for salary reduction contributions ($19,500 in 2020). Consequently, for employees with other retirement plans such as a 401k or 403b plan, the sum of all pre-tax contributions cannot exceed $19,500. An employee can also choose not to contribute to the SIMPLE IRA.

Catch-up contribution

The catch-up contribution is a feature that exists in many retirement plans to help older employees catch up on their retirement savings. In a SIMPLE IRA account, employees 50 or older can contribute an additional $3,000 each year to their retirement savings. This raises the contribution limit from $13,500 to $16,500.

Employer contribution

As an employer, you must contribute to the employees’ SIMPLE IRA. You have two options to make your contributions:

• matching contribution
• nonelective contribution

Depending on your employees’ contribution history and compensation levels, you can choose one that’s most cost-effective for your business.

Matching contribution

Under this method, the employers will match each employee’s contribution dollar-to-dollar up to 3% of the employee’s compensation. For example, if an employee contributes 2% of their salary to the SIMPLE IRA, the employer must match the 2% contribution. However, if the employee contributes more than 3% to the SIMPLE IRA, the employer only needs to match the first 3%. Additionally, if the employee does not contribute, the employer can skip the contribution as well.

Further, the employer can lower the matching contribution limit from 3% to 1%. However, the lower percentage can only be used 2 out of 5 years and the employees need to be notified prior to the change.

Nonelective contribution

Employers can also contribute a flat 2% for all eligible employees by adopting the nonelective contribution method.

The 2% contribution is subject to a compensation cap of $285,000. This means the 2% contribution only covers the first $285,000 of the employee’s salary. If an employee makes $300,000 a year, your contribution will be capped at 2% of the first $285,000 of their compensation.

Investment option and distribution

The owner of a SIMPLE IRA can invest in many different financial instruments such as stocks, bonds, and fund products. With a SIMPLE IRA, you have complete freedom to manage your own investments as you would with a regular investment account.  

The distribution of your SIMPLE IRA also follows the same rules as a traditional IRA. You can withdraw from the account without penalty after you reach 59.5 and pay ordinary income tax on your withdrawal.

Setting up a SIMPLE IRA

You can set up a SIMPLE IRA plan by first executing a written agreement with information regarding the plan and contribution methods. You can use the standard forms from IRS (Form 5304-SIMPLE or Form 5305-SIMPLE) to set up a SIMPLE IRA. Alternatively, you can use a plan document provided by a bank or mutual fund.

You also need to choose a financial institution to serve as the trustee of the plan and hold the assets. There are many banks, brokerage firms, and investment companies that can serve as the trustee of your SIMPLE IRA. Once you execute the agreement and inform your employees of the plan information, you can open the accounts and start contributing.

SIMPLE 401K

Similar to SIMPLE IRAs, SIMPLE 401ks are designed for businesses with less than 100 eligible employees. The contribution rules for SIMPLE 401ks are almost identical to SIMPLE IRAs. The employees can contribute up to $13,500 a year while the employer can choose between a 3% matching contribution and a 2% nonelective contribution.

However, there are some important differences between SIMPLE IRA and SIMPLE 401K that can be easily overlooked because of their similarities. Some unique features of a SIMPLE 401k might be beneficial to your business.

Comparing SIMPLE IRA and SIMPLE 401k

Compensation cap

For SIMPLE IRAs, only the nonelective contribution method is subject to the compensation cap. Under a SIMPLE 401k plan, both employer contribution methods are subject to a compensation cap of $285,000.

For example, employer contributions only apply to the first $285k of an employee’s compensation. Any income above the cap does not affect employer contribution. If you have many employees with high incomes, this feature might have a big impact on the size of your total contribution.

Loans

SIMPLE 401ks offer a loan feature to the employees. It allows them to borrow against their SIMPLE 401k portfolios without tax or penalty. An employee can borrow up to 50% of their portfolio value as long as the total loan amount is under $50k. On the other hand, SIMPLE IRAs don’t provide this loan feature.

This feature provides more financial flexibility to the employees and helps them navigate emergencies.

Investment options

SIMPLE IRA accounts allow the employees to invest in various investment options such as stocks, bonds, mutual funds, and ETFs. In contrast, the investment option is more limited for SIMPLE 401ks. Most SIMPLE 401ks only include mutual fund investments.

Administrative burdens

A SIMPLE IRA plan has very little administrative work after the initial setup. With a SIMPLE 401k plan, the employer will need to track employee contributions and the market value of each plan. The employer is also responsible for communicating changes in the investments to the employees. Additionally, SIMPLE 401k providers must file Form 5500 each year with the IRS. Because of the work involved in overseeing a SIMPLE 401K plan, many employers work with a service provider who takes care of the ongoing administration for the plan.

Conclusion

Offering a retirement plan to your employees is a great way to attract and keep your best workers. However, good intentions only go so far. As a business owner, you have the task to choose the right plan for your business and employees. A good understanding of the options available will help you become more informed. It also helps you better communicate with the professionals who can help you set up and manage the plans.