Editorial · December 8, 2018
SIMPLE IRA vs 401(k): Small Employer Plan Choices
SIMPLE IRA vs 401(k) is the first retirement plan choice many small employers face, and the short answer is this: a SIMPLE IRA is cheaper and easier to run, while a 401(k) lets employees save more and gives the employer more control. Both are real options for a business with a few dozen workers. Here is how they compare for 2018.
The quick answer
Pick a SIMPLE IRA if you want low cost and little paperwork. Pick a 401(k) if you want higher limits and flexible employer contributions, and you can handle more rules. The IRS says a SIMPLE IRA plan suits small employers that do not have a retirement plan yet. A SIMPLE IRA is open to employers with generally 100 or fewer employees. A 401(k) has no such size cap.
Contribution limits for 2018
The IRS published the 2018 limits in Notice 2017-64. An employee can defer up to $18,500 of pay into a 401(k) in 2018, up from $18,000 in 2017. Workers who are 50 or older can add a $6,000 catch-up on top of that.
A SIMPLE IRA has a lower cap. The employee limit stays at $12,500 for 2018. The catch-up for workers 50 or older is $3,000. So a saver in a 401(k) can put away about $6,000 more each year than a saver in a SIMPLE IRA.
There is also a ceiling on total contributions to a 401(k) account. For 2018 the limit on combined employee and employer contributions to a defined contribution plan rises from $54,000 to $55,000. The annual pay that counts toward plan formulas is capped at $275,000.
What the employer must pay
A SIMPLE IRA requires the employer to contribute every year. You choose one of two formulas. The first is a match of up to 3 percent of pay for workers who contribute. The second is a flat 2 percent of pay for every eligible employee, even those who save nothing.
The IRS gives two examples. A worker earning $50,000 who saves 5 percent puts in $2,500. With a 3 percent match, the employer adds $1,500, so $4,000 goes into the account. Under the 2 percent formula, a worker earning $40,000 gets $800 from the employer whether or not that worker saves. Employees are always fully vested in a SIMPLE IRA, which means all of the money is theirs right away.
A 401(k) is more flexible. The employer may make no contribution, match employee deferrals, contribute for everyone, or do both. Employer money can follow a vesting schedule, so an employee earns full ownership over time. That can help with retention, and it is a tool a SIMPLE IRA does not give you.
Setup work and paperwork
This is where the two plans differ most. The IRS says a SIMPLE IRA can be set up by adopting Form 5304-SIMPLE or Form 5305-SIMPLE, a prototype plan or a custom document. The employer generally has no annual filing requirement. The IRS also lists "no discrimination testing required" as a benefit.
A traditional 401(k) asks for more. The employer must run annual nondiscrimination tests, called the ADP and ACP tests. These check that pay deferred and matching money do not favor highly paid staff. If the tests fail, the plan has to be corrected.
A safe harbor 401(k) is a middle path. It is similar to a traditional plan, but the employer contributions are fully vested when made, and the plan is not subject to the annual ADP and ACP tests. The employer must also send each eligible employee a written notice about the plan.
Rules that can catch you out
A SIMPLE IRA comes with a few firm limits. The employer cannot have any other retirement plan at the same time. Loans from the account are not allowed. Employees can withdraw money, but the amount counts as income, and a worker under age 59 and a half owes an extra 10 percent tax. If the withdrawal happens in the first two years of taking part, that extra tax rises to 25 percent.
The contribution formulas are also fixed. If cash is tight in a slow year, you still owe the match or the 2 percent. A 401(k) with a discretionary employer contribution gives you room to adjust. Weigh that against the extra testing and administration.
How to decide
Start with three questions. How much do you want key staff to be able to save? How steady is your cash flow? How much admin time can you give the plan?
A small shop with steady pay and a short to-do list often does well with a SIMPLE IRA. A growing firm with highly paid owners, or one that wants a vesting schedule or higher limits, should look hard at a 401(k). Safe harbor designs can cut the testing burden.
Before you sign anything, ask a plan provider for a written fee list, and talk with a tax adviser about your own numbers.