What Is The Difference Between 401(k) and SIMPLE Retirement Plans?
Brad Smith • February 29, 2020
SIMPLE 401(k) plans combine the features of traditional 401(k)s with the simplicity of SIMPLE IRAs. Companies with 100 or fewer employees can establish SIMPLE 401(k) plans. SIMPLE 401(k) plans work like traditional 401(k)s, but employee contributions are capped at a lower annual amount.
Among all the retirement plans, the most common is the SIMPLE IRA or SIMPLE 401(k) (highly popular among the Small and Medium
Enterprises (SMEs)) and regular 401(k) plans.
Each one comes with its pros and cons and is suited for a different segment. In this article, we will have an in-depth analysis of different plans, their comparison, and which is best for SMEs who don’t have deep pockets. So, let’s dive in!
Traditional and Roth 401(k) plan
First, let’s compare the traditional and Roth offerings.
Traditional 401(k) is a retirement plan
in which both the employer and employee contribute. The plan allows employees to contribute up to $19,500: in some cases, even $26,000 if they’re at least 50 years old. This amount is before the deduction of taxes. On the other hand, employers can also contribute up to the same limit. The only condition is that they will have to enroll in a Roth account under the 401(k) plan.
These terms and conditions can be tempting for employees, especially if matched by generous contributions of employers.
Even though 401(k) plans are a great way to attract talented people, they come with their complications. It requires an all-out effort to design and maintain the retirement plan. Not to forget the complexities of managing the Form 5500 compliance, reporting obligations, and fulfilling the record-keeping criteria. Last but not least, there are fiduciary problems to be dealt with. Without the support of a third party, all this can be overwhelming for SMEs.
Due to above nuances, it is common for SMEs to turn to less complicated alternatives.
SIMPLE Individual Retirement Accounts (SIMPLE IRAs)
As you might have guessed from its name, SIMPLE IRAs (Savings Incentive Match Plan for Employees Individual Retirement Accounts) provide individual accounts in the name of the employees as opposed to a general fund. This means that you have full control over the account. These were specially designed for SMEs who don’t have a large workforce and can hence afford to have designated accounts.
Having an individual employee account might seem to be an expensive task, but it isn’t. In fact, the low cost is the primary reason why SIMPLE IRA is popular among companies looking for cost-effective retirement plans. The primary reason for the low cost is that there are no complicated reporting requirements, nor it takes a lot of effort to design a SIMPLE IRA plan. Furthermore, there is no Form 5500 requirement, as well. This is quite a relief for small businesses that don't have time and resources for all the paperwork.
Amidst all these differences, there’s one commonality between SIMPLE IRA and traditional 401(k) plans i.e., the monetary contribution is on a pre-tax basis. Moreover, the tax is not recurring and only applies when the employee withdraws the amount.
For example, an employee starts investing in a retirement fund from today and continues doing so for the next thirty years. After thirty years, when he/she withdraws the amount, the tax would be applicable. One thing that should be noted is that a 10% penalty applies if the withdrawal is made before the age of 59.5 years.
Now comes the pertinent question of how much contribution can be made to the SIMPLE IRA plan. An employee can contribute up to $13,500 with employees above 50 years, having the margin to contribute an additional $3,000. Compare this to the regular 401(k) plan, and you will see the difference yourself.
Let’s have a look at another difference. SIMPLE IRAs make it compulsory for employers to contribute to the employee's account. This could be in the form of a fixed 2% pay of the employee salary or the same amount as the other party is contributing. The interesting point is that in the former case, it is not necessary for the employee to contribute to the fund.
Another interesting feature of the SIMPLE IRA plan is that the employees are in full control of the entire fund. They are not required to share the funds with the employer or any other entity. Furthermore, there aren’t any annual nondiscrimination testing for employer’s plan as it happens in regular 401(k) plan.
Before we jump to the next plan, let’s shed some light on the eligibility criteria for the SIMPLE IRA plan. The criteria is pretty straightforward. Any employee who has earned $5000 or more in the current year is eligible. Also, any employees who have received a minimum of $5000 in any two preceding years qualify for this plan. It should be noted that these two years need not necessarily be consecutive. Please take a look at our different online forms here
to get started on planning your future.
What is SIMPLE 401(k)s?
This is one of the most interesting retirement plans
as it has a lot of common ground with SIMPLE IRA plan. For example, all contributions are pre-tax, employee contribution threshold is the same, only small business can participate, and even the reporting obligations are similar.
Well, you might be wondering then why this plan exists?
Let us walk you through the nuances.
In SIMPLE IRA plan, we saw that employees should have received a minimum of $5000 in compensation in any two-preceding years (nonconsecutive also applies). The same rule applies to SIMPLE 401(k) plan but with a subtle difference. The employer has the choice to make the employees wait until the age of 21 years or a one-year service before they are qualified for the plan. Note that we have mentioned this is not compulsory, but the employer can exercise this option without any legal complications.
Another important point to note is that employers are required to contribute the same percentage as it was in SIMPLE IRA plan. However, the contribution would only be limited to the first $285,000 earnings of the employee. After that, the employer has the choice to withdraw his contribution if he wants to do so.
Should I Switch To a Regular 401(k) Plan?
Now, we have gone through all the details of different retirement plans for SMEs. However, as these companies grow, these plans become useless. You need something to cater to the larger workforce and their requirements.
This is where the regular 401(k) comes into play. It has high contribution limits allowing employees to take a higher amount post-retirement.
Before we have an in-depth analysis of the regular 401(k) plan, do keep in mind that you cannot switch to a new plan before January 1. That means it is crucial to sit down and formulate a comprehensive plan before the year ends.
As a regular 401(k) plan is designed for larger corporations, it has a lot of paperwork compared to a SIMPLE IRA or SIMPLE 401(k) plan. However, that shouldn't scare you. The employee loyalty you will win as a result of an enhanced retirement plan should be enough to offset the cost associated with special provisions.
So, this was a comprehensive guide of the various retirement plans at your disposal. As you have seen, each plan has its pros and cons. Therefore, you should sit down with your team and have a birds-eye view before finalizing anything.
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