SIMPLE IRA vs. 401k – Which is better for a small business owner?
SIMPLE IRA vs. 401k – Which is better for a small business owner?
When I started my business, I wasn’t concerned about my retirement plan. I was really only thinking about how I could pay my employees, cover my home mortgage payment, and have food on the table for my family. You know, the basic necessities of life. After a couple of years, was able to hire more employees and as we grew, I realized how top notch these people really were. It was only then that I realized I needed to offer a retirement plan. As a small business owner, I thought it might be fairly difficult to find an affordable option. I know now there are good options for everyone (you can read about how to build a small business benefits package here) but it takes time and intentionality to sort through.
After reviewing the pros and cons of all my options, I decided on a SIMPLE IRA, which stands for Savings Incentive Match Plan for Employees Individual Retirement Account. This was a great option at the time for a few reasons. Mainly it was cheap and there wasn’t a bunch of compliance red tape to sort through. It gave me the opportunity to offer a retirement plan to my employees, and if they didn’t elect into it, it didn’t cost me anything. And for someone who didn’t have a lot of money to fully fund my retirement in the beginning, it was the perfect option. I didn’t have to worry about maxing out the most I could tax defer with a SIMPLE IRA, or even close to the max amount for a 401k.
In my experience, most new small business owners find themselves in similar circumstances at the beginning. However, as the business matures and there is more money flowing through, owners often find themselves wanting to fund more into their personal retirement funds than a SIMPLE IRA allows. When I got to this point, I needed to weigh my options through a pros and cons list. Whether you find yourself in a similar situation or are planning for the future, let’s compare the SIMPLE IRA and 401K options to see which one might be better for your business.
What is a SIMPLE IRA?
A SIMPLE IRA is easy to set up and administer. You don’t need to file annual reports with the IRS or hire a third-party administrator. You just need to open an account for each eligible employee and contribute on their behalf. You can either match your employees’ contributions up to 3% of their salary or make a fixed contribution of 2%, regardless of whether they contribute. Your contributions are tax-deductible, and your employees’ contributions are tax-deferred.
Sounds perfect, right? A SIMPLE IRA is exactly that – simple. However, there are some drawbacks to this kind of plan:
- The contribution limits are lower than a 401(k) plan. For 2023, the maximum annual contribution for a SIMPLE IRA is $14,000, or $17,000 if you’re 50 or older.
- You can’t offer any other retirement plan to your employees if you have a SIMPLE IRA.
- You can’t impose vesting requirements on your contributions, meaning your employees can take them with them if they leave your company.
How does a 401K Plan differ?
A 401(k) plan is more complex and costly to set up and maintain. You must file annual reports with the IRS and hire a third-party administrator to handle the paperwork and compliance issues. You also need to choose an investment provider and select the investment options for your plan.
Although a 401K Plan requires more maintenance, it provides you more flexibility in terms of your involvement and contributions. For instance:
- You can decide how much to contribute to your employees’ accounts by matching their contributions up to a certain percentage of their salary or by making a profit-sharing contribution based on your company’s performance.
- You can impose vesting requirements on your contributions, meaning that your employees have to work for a certain period of time before they can claim them.
- Your contributions are tax-deductible, and your employees’ contributions are tax-deferred.
- With a 401K, you can offer other retirement plans to your employees.
The main advantage of a 401(k) plan is that the contribution limits are higher than a SIMPLE IRA. For 2023, the maximum annual contribution for a 401(k) plan is $20,500, or $27,000 if you’re 50 or older.
If you decide to set up a 401(k) plan, check out our other article about the Top 3 Mistakes to Avoid When Setting up a 401(k).
How to choose the right plan
So, with this information, which one should you choose?
The worst answer and the one you were hoping I wouldn’t say is… it depends. I know this is a cop-out, but it really does. Your business size, budget, goals, cash flow, age, etc., create different facts and circumstances when deciding which is best for you.
Most small businesses could be initially served by choosing a SIMPLE IRA. If you have fewer than 100 employees, want to keep things simple and low-cost, and don’t mind the lower contribution limits and lack of vesting options, SIMPLE IRA is a good option for you. Alternatively, a 401(k) plan might be better if you have more than 100 employees, want to offer more flexibility and customization, and can afford the higher costs and administrative burden.
If you’re looking for a way to boost your retirement savings, consider adding a profit-sharing plan to your 401k. A profit-sharing plan is an employer-sponsored retirement plan that allows you to share in your company’s profits. Depending on the plan design, you could contribute a percentage of the company’s profits, a fixed amount, or a discretionary contribution to your employees.
The benefit of having a profit-sharing plan along with your 401k is that you can max out the most tax-deferred income possible. The IRS sets annual limits on how much you can contribute to your 401k, but those limits don’t include employer contributions. If you contribute to the 401k and profit-sharing plan, you can truly max out your allowable tax-deferred income.
For example, in 2023, the 401k contribution limit is $20,500 for employees under 50 and $27,000 for those 50 and older. The total combined limit for employee and employer contributions, however, is $61,000 and $67,500 respectively. If you contribute $10,000 to your 401K plan as the owner, you also can contribute $20,000 to your company’s profit sharing plan. By doing this, you can save up to $50,500 or $57,000 in tax-deferred income, depending on your age.
The decision between SIMPLE IRA or 401k is up to you.
Ultimately, only you can decide what is the right retirement option for you and your business. Whatever you decide about a SIMPLE IRA or 401k, remember that offering retirement benefits to your employees is not only good for them, but it can also be good for you. It can help attract and retain talent, boost morale and productivity, and reduce turnover and taxes.
We have created a Retirement Plan Option guide to help you determine which option is the best for you. If you need help, we are happy to have a conversation. Schedule a time to talk with us here, or keep exploring our resources about providing benefits as a small business owner.
**If you are reading this article in the fall of 2023 when it was published, your time is running out to get this set up for this year and contribute! To contribute to a SIMPLE IRA, you have to have this set up by October 1, 2023. Fortunately, because of their simplicity, setting a SIMPLE IRA up takes about 10 minutes. For a 401k, you have until December 31, 2023 to set it up and can make contributions until April 15, 2024. Of course, the sooner you start saving, the better. So don’t wait too long to get started!