SIMPLE IRA: A Smart and Easy Option for Retirement Savings

Source: 401kcalculator.org via Flickr.

If you're self-employed or the owner of a small business, not having access to a 401(k) plan may seem like a serious disadvantage when it comes to saving for retirement. Fortunately, there are several types of retirement accounts designed specifically for individuals just like you -- and a SIMPLE IRA could be the answer you're looking for.

What is a SIMPLE IRA and how can it help you invest?SIMPLE IRA stands for Savings Incentive Match Plan for Employees, and the account was designed to be a hassle-free way for employers without 401(k) or similar retirement plans to set aside and invest money for their employees' retirement.

The SIMPLE IRA is a common choice for self-employed individuals, but any small business with fewer than 100 employees and no other retirement plan is eligible to use a SIMPLE IRA. There are several reasons a SIMPLE IRA can be a smart choice:

  • Establishing a SIMPLE IRA plan is, well, simple. There are no filing requirements for employers, and the plan is low-maintenance.
  • Contribution limits are significantly higher than traditional and Roth IRA accounts. As we'll see shortly, SIMPLE IRA account holders have the ability to contribute significantly more than the annual $5,500 annual cap associated with other IRAs.
  • Once money is contributed to a SIMPLE IRA, it can be invested in virtually any stock, bond, or fund the account holder chooses. In contrast, 401(k) investments are generally limited to a small selection of mutual funds.
  • Employer contributions are mandatory, giving employees peace of mind. In a 401(k) plan, employers have the option to suspend their matching programs whenever times get tough.

Employee and employer contributionsContributions to a SIMPLE IRA can come from both the employee and the employer. It's also important to note that self-employed individuals are considered to be both the employee and employer, so they can take full advantage of the generous limits.

Employees can choose to contribute up to $12,500 in 2015 on a pre-tax basis, meaning that any elective contributions reduce their taxable income. Participants over 50 years of age have a special "catch-up" provision that allows for an additional $3,000 in annual contributions for a total of $15,500. It's also important to note that these limits can (and will) change over time to account for cost of living increases.

There are a couple of details worth mentioning, here. First, employees can contribute the limit or their total compensation, whichever is less. For example, if an employee earned $10,000, he or she can only contribute that amount to their SIMPLE IRA -- not the full $12,500 limit. Second, if an employee participates in any other employer-sponsored retirement plans, such as a 401(k) through a part-time job, the total annual elective contributions to all employer plans cannot exceed $18,000 for the year ($24,000 if over 50).

On the employer side, one distinguishing feature of the SIMPLE IRA is that employer contributions are mandatory. Employers have two choices, here -- they can either match their employees' contributions up to a maximum of 3% of the employee's salary, or they can choose to make a contribution equal to 2% of each employee's salary, regardless of whether or not the employee contributes.

For example, consider a hypothetical employee who earns $50,000 per year and chooses to contribute 10% of his salary to his SIMPLE IRA, or $5,000. His employer could choose to match the first $1,500, or simply contribute 2% of his salary, or $1,000. So, depending on the employer's choice for their business (the policy must be the same for all employees in a business), this employee would have either $6,000 or $6,500 contributed to his SIMPLE IRA for the year.

An example for self-employed individualsAs I mentioned, self-employed individuals are considered to play both the employee and employer role for contribution purposes.

So, let's say that you are a 40-year-old successful business owner and that you earn $200,000 in 2015. You are allowed to make an employee contribution of $12,500, as well as the maximum employer contribution of 3% of your salary ($6,000). In this case, your maximum contribution into your own SIMPLE IRA for 2015 would be $18,500.

DrawbacksWhile a SIMPLE IRA is an excellent retirement option, there are some potential drawbacks. For example, other self-employed retirement accounts such as a SEP-IRA or an individual 401(k) allow for much higher contribution limits. And the fact that employer matching contributions are limited to just 3% of salary is a significant disadvantage when compared to many 401(k) plans.

Finally, since the account is structured as an IRA and not a 401(k), the IRA early withdrawal and borrowing rules apply. Specifically, 401(k) accounts allow participants to borrow money, something that's not an option in IRAs. However, there are reasons you can withdraw money from a SIMPLE IRA early, such as for a first-time home purchase.

Contribute early and oftenThanks to the awesome power of compound investment gains, your SIMPLE IRA contributions could add up quickly.

For example, if you're 35 years old, self-employed, earn $100,000 per year, and choose to max out your SIMPLE IRA contributions, you would be able to contribute $15,500 ($12,500 employee/$3,000 employer). Assuming you max out your contributions every year until you're 65, you could be sitting on a $1.6 million nest egg by the time you retire, assuming a historically conservative 7% average annual return. And that doesn't include any salary or contribution limit increases that are likely to occur along the way.

The bottom lineA SIMPLE IRA can be an excellent way to save for retirement if you're self-employed, or if you're a small business owner who wants to offer retirement benefits to employees. By maximizing your contributions and investing wisely, you can create a retirement nest egg that could be the envy of all of your 401(k)-owning friends.

The article SIMPLE IRA: A Smart and Easy Option for Retirement Savings originally appeared on Fool.com.

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