Should your company be sponsoring a Simple IRA or 401(k) plan? These are the two most common employer sponsored retirement plans for companies that have employees. There are a lot of differences between these two types of plans:
- Eligibility Requirements
- Contribution Limits
- Employer Contribution Formulas
- Establishment Dates
- Distribution Options
- Plan Features
While most investment advisors have a good understanding of 401(k) plans, fewer advisors understand how a Simple IRA works versus a 401(k). As a result, you have a lot of companies that are currently sponsoring a 401(k) plan that probably should have set up a Simple IRA instead.
There is a big difference in employee eligibility requirements. Each plan defines a “year of service” differently:
- 401(k) Plan: 12 months & 1000 hours
- Simple IRA: $5,000 in compensation
If the company’s goal is to only cover “full time employees” then a 401(k) plan may make more sense because with a Simple IRA if they earn more than $5,000, that employee is credited with a year of service. With the 401(k) plan they have to work for you a year and work 1000 hours during that one year period.
However, Simple IRA’s allow a longer wait time before employees are eligible to enter the plans. With a Simple IRA, you can keep an employee out of the plan for two years and then in the third year they would be eligible for the plan. With a 401(k) plan the maximum eligibility period is one year.
Simple IRA’s and 401(k) plans both have employee deferrals and employer contributions but there are some key differences:
- Employee deferral limits for Simple IRA’s are lower than 401(k) plans
- Employer contributions are mandatory for Simple IRA plans
- Mandatory 100% vesting for Simple IRA plans
Even though the contribution limits for Simple IRA’s are lower than 401(k) plans sometimes that is the right fit for the company. If we have a business owner that tells us that they personally only want to contribute $12,000 to the plan for themselves, the deferral limit in the Simple IRA will allow that so there is no need for the full 401(k) plan. Plus there is no year end discrimination testing associated with Simple IRA plans so the owner does not have to worry about getting money kicked back to them for failed testing which is the case for some 401(k) plans.
Simple IRA’s have a required employer contribution
With a 401(k) plan the company can choose to make or not make an employer contribution for the employees. With a Simple IRA plan, an employer contribution is mandatory. You have two contribution formulas to choose from:
3% matching contribution
With the 2% non-elective contribution you have to provide an employer contribution to each eligible employee equal to 2% of their annual compensation regardless of whether or not they contribute to the Simple IRA plan.
The more popular option is the 3% matching contribution. With the matching contribution the employee has to contribute their own money to the plan to gain access to the employer matching contribution. It’s a dollar for dollar match up to 3% of compensation. But there is a special rule associated with the match. A company can reduce the 3% match down to a 1% match in 2 out of any 5 consecutive years. For example, if I start a Simple IRA for my company this year, I could start by offering the plan with a 1% employer match for the first two years but then I would be required to match 3% for years 3, 4, and 5.
Simple IRA’s have 100% vesting
Unlike 401(k) plans that allow employer to attach a vesting schedule to their employer contributions, all contributions to a Simple IRA plan are 100% vested.
Simple IRA’s have lower fees
One of the main reasons that may lead a company to sponsor a Simple IRA instead of a 401(k) plan is Simple IRA plans are easier to set up and they have lower plan fees. Since 401(k)’s are qualified plans that have more detail plan documents, year-end testing, a 5500 filing requirement, all of which require a third party administrator to facilitate these items. A Simple IRA is “self-administered” and they are “simple” to run. They do not have that added layer of administration costs like 401(k) plans have.
Even though there are less compliance tasks associated with a Simple IRA when compared to a 401(k), there are still compliance requirements that companies need to be aware of. It’s even a little more dangerous for companies that sponsor a Simple IRA because you do not have a TPA firm telling you what to do to keep your plan in compliance like you do with a 401(k) plan. Here are the main compliance requirements for Simple IRA plans:
- 5304-Simple Form
- Timeliness of contributions
- Notification of eligibility
Where most companies run into trouble is with the 5304-Simple Form. Your company is required to have a 5304-Form completed and on file for EACH YEAR that the company has sponsored the plan. It’s likely one of the first things the department of labor or the IRS is going to ask for during an audit. That form, which can be printed off of the IRS website, tells the employees:
- Eligibility requirements
- Employer contribution for that plan year
- Who to submit their salary deferral elections to within the company
You have to distribute that notice each year to your employees between Nov 1st and Dec 1st for the next calendar year. If you are missing that form in your employer files, the IRS will assume that all employees were eligible day 1 of employment and missed employer contributions will be due along with penalties. Ouch!!
Timeliness of contributions is another big compliance requirement for both Simple IRA’s and 401(k) plans. Since you are withholding money from employees paychecks for their employee deferral contributions, the IRS wants you to remit those contributions to their retirement accounts “as soon as administratively feasible”. If you typically send in the deferrals 1 week after the payroll is run but there is one week during the year that you sent them 2 days after the payroll was run, all of your previous deferrals can be determined “late” and the employer has to pay a penalty. The IRS will ask you, “since you submitted that one contribution 2 days after the payroll run, could you have done that for all of them?” So be careful.
If you are not sure which retirement plan is right for you, please read our article Comparing Different Types of Employer Sponsored Retirement Plans.
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group
and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.