SIMPLE IRA or Simply a 401(k)?
Which is Right for You? SIMPLE IRA or Simply a 401(k):
Taking the Guesswork Out of Deciding
Which path to follow, A SIMPLE IRA or a safe harbor 401(k)? On the surface, SIMPLE IRAs may be more attractive because they are easy to establish and maintain. However, 401(k) plans may offer considerably more flexibility in design, contribution range and access to accumulated balances. In addition, they may offer better tax diversification options, provide robust asset protection and often help to better manage costs of employee benefits.
The table below summarizes key characteristics and distinctions between these two plans:
| SIMPLE | 401(k) | |
| Eligible Employer | Employers with fewer than 100 participants who earned $5,000 or more. | Any employer regardless of the number of employees. |
| Who Should Be Included in the Plan | Any employee who received at least $5,000 in compensation during the calendar year and in the prior 2 years, regardless of hours or age | Employees must first meet eligibility Requirements: age 21, one year of service (12 months with at least 1,000 hours). Employer may be less restrictive.* |
| Maximum Contribution | Deferral: $15,500 ($19,000 when 50 or older) – 2023 Required Employer Contribution: a dollar-for-dollar match up to 3 percent of compensation to participants who defer or a 2 percent fixed contribution to all | Deferral: $22,500 ($30,000 when 50 or older) – 2023 Discretionary Employer Contribution: match or profit-sharing up to the maximum of $66,000 ($73,500 if 50 or older). The maximum may not exceed individual’s compensation and includes salary deferrals. |
| Flexibility in Employee Contribution | Employer contributions are mandatory in each year. The match may be reduced to 1 percent no more than two out of every five years. May not be terminated midyear. | An employer may choose whether or not and how much to contribute annually. Safe harbor contributions may be stopped prospectively. The plan may be terminated mid-year |
| Contribution Types | Pre-tax: traditional employee deferrals and employer contributions. After-tax: Roth employee deferrals. | Pre-tax: traditional 401(k) deferrals and all employer contributions. After-tax: Roth 401(k) deferrals or after-tax employee contributions. |
| Ability to Tailor Contributions Based on Employee Groups | None. All participants receive the same allocation match or fixed contribution | Employer may base contributions— match or profit-sharing—based on a variety of factors, including compensation, deferral levels, job classification, location, etc. |
| Vesting | All contributions are immediately vested. | Salary deferrals are fully vested. Employer contributions may be subject to a vesting schedule, e.g., incremental vesting of 20 percent per year over a six-year period. |
| Access to Tax-Free Distributions | None. | A qualified distribution from Roth 401(k) balances or in-plan Roth conversions is distributed tax-free. |
| Penalty-Free Access in Pre-Retirement | None. In certain circumstances, participants may have access to funds tax-free for up to 60 days using indirect IRA rollover approach. Otherwise, premature distribution penalty may apply; 25% if accessed in the first two years, 10% after two years | Participants may access up to the lesser of 50% of their vested balance of $50,000 through a plan loan. Plan loan is tax-free and penalty-free if repaid timely within terms specified by the plan and regulations |
| Ability to Pair Up with Another Plan | None. Must operate as the only plan for full calendar year | Yes. May be combined with another plan for testing purposes to improve outcomes or to increase tax- deductible contributions, e.g., addition of a profit-sharing, defined benefit or cash balance plan. |
| Asset Protection | Under Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). BAPCPA applies only to assets in bankruptcy. No dollar limit. May be limited if rolled over to an IRA; depends on state law | Unlimited protection under Title I of ERISA for plans that cover both owner-employees and non-owner employees. Plans covering only owner-employees are protected under BAPCPA 2005. |
SIMPLE IRA v. 401(k) Plan Case Study
A small business owner in New York asked for assistance evaluating plan options for her practice. We were asked to help determine whether a SEP, SIMPLE or a 401(k) plan would help best meet her objectives. The table below illustrates the outcome of each funding scenario net of employee and plan maintenance costs:
Facts:
S-corporation
Single owner with a W-2 of $140,000 per year; remainder of profit is treated as pass-through income on Schedule K-1
Two eligible employees earning $32,500 and $40,000
Objectives: establish a flexible employee retirement savings plan, maximize contribution opportunity and tax benefits for the owner; provide benefit to employees; manage overall benefit costs
Options Analysis:
| SEP IRA | SIMPLE IRA | 401(k) | |
| Owner contribution | $35,000 | $23,200 | $73,500 |
| Contribution for employees | ($18,125) | ($2,175) | ($5,710) |
| Annual plan maintenance fee | _ | _ | ($2,150) |
| Tax savings, net of employee contributions and fees* | ($2,188) | $5,438 | $15,903 |
| Lost tax-savings opportunity | ($18,091) | ($9,491) | _ |
Bottom Line: While SIMPLEs and SEPs offer a streamlined setup, low maintenance and minimum annual fees, the lost tax savings opportunity may be costly: ~$18,000 (SEP) and ~$9,500 (SIMPLE) in the above examples, even after the administration costs associated with a 401(k) plan are taken into consideration. In addition, the 401(k) plan option offered additional flexibility, tax-diversification options (ability to accumulate and later access assets on a tax-free and tax-deferred basis), better-managed employee benefit costs, allowed additional targeted contributions to employees as a reward mechanism, and robust asset protection under Title I of ERISA.
Here to Help
With the end of the year just around the corner, now is the time to start reviewing retirement plan options to identify optimal design, increase tax efficiency and build retirement account balances. We are prepared to assist you with:
1. Plan Design: Review all available options and identify an optimum solution in light of all relevant facts.
2. Retirement Accumulation: Find the savings vehicle that efficiently and effectively meets your objectives.
3. Tax Savings: Work to reduce the unnecessary tax exposure through tax benefits inherent in qualified plans.
4. Investment Platform: Review current platform for fees and services or help identify best options for a new plan.
*Pre-SECURE Act of 2019, employers were generally allowed to exclude part-time employees (those who work less than 1,000 hours per year) from participation in their retirement savings programs. SECURE Act, in essence, created a dual eligibility requirement for 401(k) plans: completion of either (1) a one year of service requirement (with the 1,000-hour rule) or (2) three consecutive 12-month periods with at least 500 hours of service (3-12-500 rule). The age 21 requirement may continue to apply if desired. Part-time employees who become plan participants under the new 3-12-500 rule are not required to receive any employer contributions, even when a plan is top heavy; and they are dropped from coverage and non-discrimination testing, including the salary deferral nondiscrimination test. The effective date of this provision is for plan years beginning after December 31, 2020, and since service before January 1, 2021 may be disregarded for purposes of this rule, first part-time employees will not become eligible for 401(k) enrollment until some point in 2024.
**Assumes that top dollar is taxed at a combined 30 percent federal and state income tax rate. Individual results may vary.
NOTE: Individual results will vary based on plan design, census data, earnings history, and governing regulations. The illustration provided is for informational and educational purposes. It is not intended to provide, and should not be construed as ERISA, tax, investment, legal or financial advice or guidance.
Distributions from traditional IRAs and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59½, may be subject to an additional 10% IRS tax penalty.
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