SIMPLE IRA vs. Traditional IRA: An Overview
A traditional IRA can be set up by any person who has earned income and wants a tax-advantaged way to save for retirement. A SIMPLE IRA is designed to be opened by a small business owner on behalf of up to 100 employees, including the owner if that person is a sole proprietor.
Only the owner of a traditional IRA makes contributions to the account. Both the employee and the employer make contributions to a SIMPLE IRA, which stands for Savings Incentive Match Plan for Employees.
Key Takeaways
- Traditional IRAs are set up by individuals, while SIMPLE IRAs are set up by small business owners for employees and for themselves.
- Traditional IRA contributions are made by the individual only, but SIMPLE IRA contributions can be from both an employee and employer.
- The key requirement for a traditional IRA is that you have earned income during the year, while SIMPLE IRAs may have other restrictions, put in place by the small business owner.
- The two also have different yearly contribution limits.
- For tax years 2021 and 2022, a traditional IRAs has a $6,000 annual limit (plus a $1,000 catch-up contribution for those 50 and older), while the SIMPLE IRA limit is $13,500 (plus a $3,000 catch-up contribution).
SIMPLE IRA
To contribute to a traditional IRA requires only that a person has earned income during the year.
By contrast, small business owners who open SIMPLE IRAs for their employees may make additional stipulations about who can participate. Employee contributions to a SIMPLE IRA are not tax-deductible.
SIMPLE IRA contributions are made before income taxes are deducted. Contributions to SIMPLE IRAs reduce taxable income, but they are not deductible on your tax returns as they do not appear in your taxable income.
However, sole proprietors may deduct both salary reduction contributions and matching contributions, using Form 1040.
With a SIMPLE IRA, an employee may contribute $13,500 per year for tax years 2021 and 2022. For those who are 50 years or older, the IRS catch-up provision allows an additional $3,000 for a total of $16,500 maximum contribution.
The SIMPLE IRA contributions can be either matched dollar for dollar by the employer, up to 3% of the employee’s compensation, or the employer’s contribution can be a fixed amount of 2% of the employee’s compensation.
Both traditional and SIMPLE IRAs allow for deferment of income tax on amounts contributed to the plans until they are dispersed, as well as on any earnings as long as they remain in the plans.
Traditional IRA
For traditional IRAs, the maximum allowable contribution for 2021 and 2022 is the smaller of $6,000 (or $7,000 for those 50 and older) or the person’s total income for the year.
While employee contributions to a SIMPLE IRA are not deductible, contributions to a traditional IRA can be tax-deductible.
That is, contributions to traditional IRAs are made on a pre-tax basis. The tax deduction is taken that year. Taxes will be due when the money is withdrawn, presumably after the person retires.
This is different from a Roth IRA, which is funded with after-tax money. For Roth IRAs, the money can be withdrawn tax-free during retirement.
Both traditional and SIMPLE IRAs incur penalties for early distribution of funds—10% in 2020—unless the money is withdrawn for specific hardship reasons or for certain exceptions defined by the IRS.
In any case, any income tax due must be paid on the amount withdrawn.
For a SIMPLE IRA, with a few exceptions, such as for people over age 59½, the penalty rises from 10% to 25% if the money is withdrawn within two years of an employer making the first deposit.
Special Considerations
A law signed in January 2020 called the SECURE Act allows more employers to offer annuities as investment options within 401(k) plans. Under the Act, insurance companies, not employers, will be responsible for offering suitable investment choices.
The Act also means that for multiple employer plans, in which small businesses can join together to provide retirement plans for employees, employers no longer have to share “a common characteristic,” such as being in the same industry.
Also, long-term part-time workers can now be eligible for plans. The threshold for eligibility is now one full year with 1,000 hours worked or three consecutive years of at least 500 hours.
Lastly, under the Act, small business employers who automatically enroll workers in their retirement plan are eligible for a tax credit to offset the costs of starting a 401(k) plan or SIMPLE IRA plan with auto-enrollment, on top of the start-up credit they already receive.
Advisor Insight
Bob Rall, CFP®
Rall Capital Management, Cocoa, FL
A SIMPLE IRA is an individual account that you hold as part of a small employer’s retirement plan. You contribute to the account via payroll deductions, and the employer also contributes with a match.
The major difference between a SIMPLE IRA and a traditional IRA is the amount you can contribute. Currently, the IRA contribution limit is $6,000 per year, $7,000 if you are over age 50. For a SIMPLE IRA, you can contribute $13,500 per year, $16,500 for 50-plus.
Both IRAs follow the same investment, distribution, and rollover rules. They are both tax-deferred accounts, so you do not pay tax on any growth or earnings until you make withdrawals, nor do you pay tax on contributions. Any withdrawals taken prior to age 59½ will result in a 10% tax penalty for both.