A traditional IRA is set up by an individual on their own behalf to save for retirement, whereas a SIMPLE IRA is set up by a small business owner on behalf of an employee (including the owner if he or she is a sole proprietor). Only the owner of a traditional IRA makes contributions to the account, whereas both the employee and the employer make contributions to a SIMPLE IRA, which stands for Savings Incentive Match Plan for Employees.

To contribute to a traditional IRA requires only having 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.

SIMPLE IRAs have much higher contribution limits than traditional IRAs, allowing you to save more in taxes upfront.

Contribution Limits

The contribution limits are also different:

  • For traditional IRAs, the maximum allowable contribution in 2020 is the smaller of $6,000 (or $7,000 for those 50 and older) or total income for the year.
  • With a SIMPLE IRA, an employee may contribute up to $13,500 per year in 2020. 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 for 2020.
  • 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.

Tax Issues

Both plans 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. But there are some key differences between the two plans.

Deductibility

Contributions to a traditional IRA can be tax-deductible, but employee contributions to a SIMPLE IRA are not deductible. An exception is that sole proprietors may deduct both salary reduction contributions and matching contributions from Form 1040.

Penalties

With certain exceptions, both plans incur penalties for early distribution of funds—10% in 2020—plus the payment of income tax on the amount withdrawn.

For a SIMPLE IRA, with a few exceptions, such as being over the age 59½, the penalty rises from 10% to 25% if the money is withdrawn within two years of an employer making the first deposit.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 and the SECURE Act

In early January 2020, President Trump signed the Setting Every Community Up for Retirement Enhancement (SECURE Act). The SECURE Act means that more employers may 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, where small businesses can joint 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. Before the Act, employers did not have to invite workers who clocked less than 1,000 hours every year to participate in a retirement plan.

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.