401(k) vs Simple IRA: What’s the Difference?
401(k) retirement plan is offered by an employer and is designed to help employees save for retirement.
The SIMPLE IRA plan, on the other hand, allows employers and employees to jointly contribute to an individual retirement account. Employers are not required to offer this plan, however, it does allow for employees who are self-employed or small business owners to save money for their retirement.
It’s important to understand the differences between these two types of accounts so you can make an informed decision in terms of saving for your future.
401(k) is a retirement savings plan sponsored by employers in the United States. The pan was first introduced in 1978 and this has become one of the most popular retirement savings for individuals to invest their income tax efficiently.
This retirement plan is well appreciated because when you retire, 401(k)s deferred taxes on your gains. This means that when you withdraw from the plan, you will pay income tax on gains and not when you earned it.
Another key feature of 401(k) is that employers are allowed to match their employees’ contributions.
That means for every dollar you contribute, the employer will also contribute a certain percentage to your plan. This matching percentage can be defined by the company’s policy.
The 2021 contribution limit for 401(k)s is $19,500. For over 50 years old, the contribution limit is $26,000.
SIMPLE IRA Definition
SIMPLE IRA which stands for Savings Incentive Match Plan for Employees is employer-sponsored that is intended for small businesses with 100 employees or less.
This means that employees and employers jointly contribute a certain percentage of the employee’s salary to the account. However, only the employees who make at least $5,000 in the SIMPLE IRA account can participate.
For regular employees, they can contribute up to $13,500 in their account per year, and employees who are over 50 years old, can contribute up to $16,500.
An employer can either match the SIMPLE IRA contributions up to 3% or contribute 2% of the employee’s salary up to the total contribution limit which is $285,000.
401(k) vs SIMPLE IRA
When evaluating a 401(k) vs SIMPLE IRA retirement plan option, it is very important to note their differences. This way, you as an individual can choose the best type of account that fits your needs and lifestyle.
The first difference between the two retirement plans is employer eligibility. As noted earlier, a SIMPLE IRA is not open to all employers as the name of the plan suggests. On the other hand, almost any employer can apply for a 401(k).
This means that SIMPLE IRA will only be available to eligible businesses with 100 employees or less.
Another difference between 401(k) and SIMPLE IRA is the eligibility of employees.
As mentioned earlier, SIMPLE IRA only allows eligible employees to contribute to this account. This means that only employees who have compensation of at least $5,000 can make Simple IRA contributions.
401(k)s on the other hand, allow any employee to contribute regardless of salary. This means that even interns and part-time employees can make 401(k) contributions under certain conditions.
Both accounts have investment options. But, the SIMPLE IRA limits the number of investment options compared to 401(k).
SIMPLE IRA has a small list of mutual funds that employees can choose from. It also restricts employers’ ability to offer other types of investments like real estate and bonds. This is because SIMPLE IRA is simple to administer and simple to offer.
401(k) allows employers an array of investment options that they can offer their employees.
However, it is important to note that the SIMPLE IRA plan is more beneficial compared to 401(k). This is because Simple IRA has lower administration costs as well as a simpler reporting system.
Administration and Contributions
401(k) is simple to administer as you need to file simple forms with each contribution. But, the employer needs to make sure that employees are participating in the plan.
As for SIMPLE IRA, it may require more work by employers as they will have to ensure that all employee contributions are made every pay period before their paychecks are processed.
Reporting and Taxation
Contribution limits for SIMPLE IRA accounts can be set as high as $13,500 or $16,500 if you are over 50 years old. On the other hand, 401(k) allows individual employees up to $19,500 contributions per year for individuals younger than 50 and $26,000 for those over 50 years old.
In addition, SIMPLE IRA wins with a larger contribution limit per year. However, the tax advantages of 401(k) make them very appealing to many individuals who are looking to save for their retirement.
Withdrawal and Penalty Fees
There is no penalty fee for SIMPLE IRA early withdrawal under any circumstances. However, 401(k) fees may be charged by the account administrator if you withdraw your funds before age 59 1/2 years old.
Which One Is Better for Your Retirement Savings Plan?
It all boils down to simple facts. If you are looking for a SIMPLE IRA vs 401(k) comparison, first determine the eligibility requirements of each account type then compare their benefits and drawbacks. This will help you choose which best fits your lifestyle and financial goals.
The SIMPLE IRA is a great choice for employees who are looking to save since it often requires less work from the employer and doesn’t require individuals to spend time on filling forms or handling investments.
On the other hand, 401(k) plans offer more benefits such as higher contribution limits and favorable taxation. Therefore, 401(k) plans are ideal for self-employed individuals.
Overall, choosing a retirement plan is simple if you compare both accounts based on their yearly contribution limits, eligibility requirements, and administration. Your final decision should be the best fit for your lifestyle and financial goals.
So we see that SIMPLE IRA and 401(k) plans are simple to understand and simple to make a choice with. But, complicated situations call for an expert’s advice.
This is why it may be important to consult a financial adviser or accountant if you need guidance on which type of plan will best suit your lifestyle and financial goals.
401(k) Plan | A Complete Beginner's Guide
The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k). Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.
Traditional 401(k) vs Roth 401(k)
There are two types of 401(k) plans: Traditional and Roth 401(k)s. The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978. With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn. Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006. Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free. Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings. Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.
Contributing to Your 401(k) Retirement Plan
Contributing to a 401(k) plan is traditionally done through one’s employer. Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion. If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade. If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion. To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn. With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them. Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire. If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term. You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket. On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true. In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up. Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change. A smart move may be to hedge your bets and divide your contributions between the two types of IRAs. If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each. In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other. When you do decide which avenue to take, make sure to thoroughly evaluate your decision. Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible. Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky. You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.
Pension vs 401(k)
Pensions are similar to a 401(k), but are a liability to a company. If an employer offers an employee a pension, it means that they are promising to pay out a set amount of money to the employee at the time of their retirement. There is typically no option to grow this amount, but it also does not require any financial investment from the employee. Pensions, also referred to as defined-benefit plans, are becoming increasingly rare because it puts the financial burden of offering a retirement fund for employees entirely on the employer. 401(k)s, which are also called defined-contribution plans, take some of the financial pressure off of an employer, while also allowing employees to potentially earn a larger retirement package than they would have with a pension.
How Much Should I Contribute to My 401(k)?
Most financial experts say you should contribute around 10%-15% of your monthly gross income to a retirement savings account, including but not limited to a 401(k). There are limits on how much you can contribute to it that are outlined in detail below. There are two methods of contributing funds to your 401(k). The main way of adding new funds to your account is to contribute a portion of your own income directly. This is usually done through automatic payroll withholding (i.e. the amount that you wish to contribute, counting all adjustments for taxation, is simply withheld when receiving payment and automatically put into a 401(k)). The system mandates that the majority of direct financial contributions will come from your own pocket. It is essential that, when making contributions, you consider the trajectory of the specific investments you are making to increase the likelihood of a positive return. The second method comes from deposits that an employer matches. Usually employers will match a deposit based on a set formula, such as 50 cents per dollar contributed by the employee. However, employers are only able to contribute to a traditional 401(k), not a Roth 401(k) plan. This is especially important to keep in mind if you want to utilize both types of plans. A key variable to keep in mind is that there are set limits for how much you can add to a 401(k) in a single year. For employees under 50 years of age, this amount is $19,500, as of 2020. For employees over 50 years of age, the amount is $25,000. If you have a traditional 401(k), you can also elect to make non-deductible after-tax contributions. The absolute limit, counting this choice and all employer contributions, is $57,000 for employees under 50, and $63,000 for those over 50 as of 2019.
Plan in Advance
401(k) Plan FAQs
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.