What Is a SIMPLE 401(k) and How Does It Work?

Quick Answer

A SIMPLE 401(k) is a subset of a standard 401(k) plan structured for small business owners with 100 employees or fewer and who have received at least $5,000 in wages each year. Funds are 100% vested and tax-deferred until distributed.

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A Savings Incentive Match Plan for Employees, or SIMPLE 401(k), is a type of employer-sponsored 401(k) plan structured for small businesses with 100 employees or fewer. It is a cost-effective way for small businesses to offer a qualified plan to employees who have received at least $5,000 in wages in the previous calendar year. For employees, a SIMPLE 401(k) can be a tax-deferred way to save for retirement, and because the money is 100% vested, it's theirs to keep.

Learn what a SIMPLE 401(k) is, how it works and the many benefits (and a few drawbacks) of this type of plan.

What Is a SIMPLE 401(k)?

A SIMPLE 401(k) is a defined-contribution plan designed for small businesses with fewer than 100 employees who earn at least $5,000 or more per year. Contributions to a SIMPLE 401(k) come directly out of the employee's paycheck and are not taxed until they begin making withdrawals in retirement. Like with a standard 401(k) plan, they can begin withdrawing funds at age 59½, and any early withdrawals may be subject to a 10% penalty and income taxes.

But, unlike a standard 401(k), contributions must be matched by the employer.

The IRS provides a two-year grace period for thriving businesses that have grown to employ more than 100 people. So, if your company was enrolled in a SIMPLE 401(k) with 85 employees but grows to employ 115 employees, you have two years to switch the retirement plan to a standard 401(k).

How Does a SIMPLE 401(k) Work?

SIMPLE 401(k) plans give employees who work for smaller businesses a way to save for retirement that can mimic the opportunities provided at larger companies. By taking advantage of an elective employer match (or even just taking the required non-elective match), employees can boost their savings even more.

Much like a standard 401(k), employees contribute pretax dollars out of their paychecks, which are invested in options laid out by a plan administrator. Contribution amounts are limited: In 2022, an employee can contribute a maximum of $14,000. If they're over 50, they can make an additional catch-up contribution of $3,000. These limits are lower than the IRS contribution limits for standard 401(k) plans.

Employers must also meet certain contribution limits set up by the IRS. These limits include matching up to 3% of each employee's pay, or a non-elective contribution of 2% of an eligible employee's wage. No other contributions can be made.

It's also worth noting that, if you offer a SIMPLE 401(k) plan to your employees, you cannot offer any other qualified retirement plans and must file IRS Form 5500 every year.

The Pros and Cons of SIMPLE 401(k) plans

If you're a small business owner with fewer than 100 employees, you might ask yourself if you should offer a SIMPLE 401(k) plan as part of your employee benefits package. Looking at some of the main pros and cons may help you decide.

Pros

  • Employee contributions to a SIMPLE 401(k) are immediately fully vested. That means employees own 100% of their contributions each year. So, even if they change jobs often, they can take the money they've invested with them.
  • Employees can take out a loan against their SIMPLE 401(k). SIMPLE 401(k) plans allow your employees to take out a loan if they need an influx of cash fast, as long as they have a plan to pay it back according to the repayment terms for the loan. If they don't repay the loan on time, it could be considered an early distribution, and they might have to pay taxes and penalties.
  • SIMPLE 401(k) plans offer considerable tax advantages. Tax savings include a tax deduction for all your employer contributions and deferred taxes on employee contributions and earnings until distribution.
  • Offering a SIMPLE 410(k) can help attract and retain employees. Even though employees may work for a small company, they can still save for retirement from contributions deducted from their paychecks. This can make it easier for you to attract employees, and they may stay on the job longer.

Cons

  • Employer contributions are mandatory. Unlike a standard 401(k), employers that offer SIMPLE 401(k) plans must match employee contributions dollar-for-dollar up to 3% of their pay or make a 2% non-elective contribution for each eligible employee. This could be a significant financial burden for a small business owner.
  • Caps are low on employee contributions. In contrast to standard 401(k) plans that cap employee contributions at $20,500 with catch-up contributions of $6,500 for individuals over 50, SIMPLE 401(k) plans cap employee contributions at $14,000 with catch-up contributions capped at $3,000 for those over 50 in 2022.
  • Employers cannot offer other retirement plans. The IRS prohibits a small business from offering any other retirement plans to employees already covered by a SIMPLE 401(k).

SIMPLE 401(k) vs. SIMPLE IRA

Like a SIMPLE 401(k), a SIMPLE IRA can provide employees with a source of income at retirement by allowing them to set aside money in a retirement account. But because both SIMPLE plans are so similar and both offer valuable tax benefits, choosing one over the other may come down to a few key differences.

How They Are Alike

  • Employers of either plan must have fewer than 100 employees.
  • Both plans have the same employer contribution limits of 3% match or 2% non-elective contribution.
  • Employers cannot offer any other retirement plans.
  • Employees in either plan are always fully vested.
  • Contributions limits are the same.

How They Are Different

  • SIMPLE IRAs do not allow employees to take out loans against their accounts.
  • Employers who offer SIMPLE IRAs and elect to make matching contributions can opt to reduce the amount to less than 3%, but no less than 1%, for two out of every five years. SIMPLE 401(k)s do not offer this option.
  • The annual tax filing of IRS Form 5500 is not required with a SIMPLE IRA.

Start Planning for Retirement Now

You may feel it's unnecessary to set money aside in a retirement plan when you're just starting out in your career—especially if you're just scraping by. But saving for retirement now by making regular contributions to a SIMPLE 410(k) plan can pay off big in the future. It's a habit that can't be learned too early.

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