Simple IRA versus Simple 401k Plans - Eligibility, Contribution Limits, Further Readings

(January 6th, 2010)

While there are many similarities between simple IRAs and Simple 401k plans, there are many differences as well. In this article, we compare and contract between Simple IRAs and Simple 401k plans.

Eligibility

i) Employers - For both the Simple 401k and Simple IRA plans, employers must have a maximum of 100 employees or less who receive at least $5000 in annual compensation. Also, employers cannot maintain any other retirement plan for their employees who are eligible for the Simple 401k other than the Simple 401k. The employers can however run another retirement plan for employees who do not qualify for making contributions into the Simple 401k.

By contrast, an employer who runs a Simple IRA for his employees is not permitted to run any other retirement program no matter what. Therefore if an employee does not qualify for making contributions to a Simple IRA while his employer only administers a Simple IRA, then too bad for that employee!

ii) Employees - Employees are normally required to perform at least 1 year of service before they are eligible to participate in an employer's Simple 401k plan. They must also be at least 21 years of age. By contrast, there is no age requirement for Simple IRA and no minimum 1 year service. Any employee who has earned at least $5000 in annual compensation in the last 2 years, and is reasonably expected to earn $5000 annual compensation this year is permitted to contribute to a Simple IRA plan.

The deadline to establish a Simple 401k or a Simple IRA is January 1st to October 1st of any given year. If a new business or corporation is formed after October 1st, then they are permitted to set up a Simple 401k or a Simple IRA. This deadline allows employees to make salary deferral contributions before the year end.

Also, because a Simple IRA is part of Individual Retirement Accounts, no loans are allowed to be withdrawn. By contrast, a hardship withdrawal or loan is permitted under the Simple 401k. Go here to learn more about 401k hardship withdrawals. Also, all contributions to a Simple 401k or a Simple IRA are 100% immediately vested.

Making Contributions to Simple 401k or Simple IRA

Employees are eligible to make salary deferral contributions to these retirement plans while employers can make matching contributions. For matching contributions, employers can make contributions of up to 3% of the employee's total annual compensation. Here are the deferral limits for both the Simple 401k and Simple IRA programs:

Investors who are 50 years of age or older can make 401k catch up contributions. Also, the matching contributions that employers can make varies from the Simple 401k to the Simple IRA. All employer matching contributions to the Simple 401k are subject to a compensation cap of $245,000 for 2009 and $245,000 for 2010. Here's an example to illustrate this concept:

Wood Corp. established a Simple 401k for its 95 employees. The company has elected to make matching contributions to each employee's 401k for the year 2007. Joe who is the Chief Financial Officer of the company is eligible to receive $250,000 in annual compensation from the company. Joe decides to make his salary deferral contribution to the maximum limit of $10,500 for 2007. The amount of matching contribution that Joe receives from his employer depends on whether it is a Simple 401k or a Simple IRA.

i) Simple IRA - Joe would receive a matching contribution of 3% x $250,000 = $7500

ii) Simple 401k - Joe would receive a matching contribution of 3% x $225,000 = $6750
Note how only $225,000 out of Joe's total compensation of $250,000 is taken into account. This is because under a Simple 401k, the employer would consider no more than $225,000 on which to make matching contributions.

3% Matching Contributions?

For the Simple IRA, an employer that decides to make matching contributions may reduce the percentage from 3% to 1% or more, for 2 out of every 5 years. The matching contribution percentage cannot be reduced less than 1%

Further Readings

For further readings, go to IRS Publication 560 - http://www.irs.gov/publications/p560/index.html It gives very useful information on setting up Simple 401k or Simple IRA plans, contribution limits, notification requirements, tax treatment of contributions, minimum funding requirements, due dates and more!