What is a SIMPLE IRA? How Do They Work?

Written by Kim PinnelliUpdated: 1st Sep 2021
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Understanding how to set up investment options as a small business owner or employer is crucial if you want to attract new talent and make sure your employees feel cared for when it comes to their retirement.

Let’s break down SIMPLE IRAs and examine how they work in detail so you can determine whether this retirement savings plan is a good choice for your business.

What is a SIMPLE IRA?

Put simply, a SIMPLE IRA is a type of retirement savings plan often used by small businesses (typically with 100 employees or fewer). The SIMPLE acronym stands for “savings incentive match plan for employees”.

It’s a type of individual retirement account (IRA) backed by a business to help its employees.

How Does a SIMPLE IRA Work?

In a nutshell, a SIMPLE IRA allows employers to make non-elective contributions of up to 2% of each employee’s salary OR a matching contribution depending on what an employee contributes to their IRA up to 3% of their salary.

In other words, employees can contribute to IRAs that receive additional contributions from their employer.

This allows the IRA to compound much more quickly and dramatically, providing better retirement savings in the long run.

How to Set Up a SIMPLE IRA (3 Quick Steps)

Setting up a SIMPLE IRA is a bit complex, so let’s break it down piece by piece.

#1. Choose a Financial Institution

To start, employers must decide if they want to choose the financial institution in which their employees will hold their individual retirement accounts.

Alternatively, they can choose to allow their employees to pick their own financial institutions. This dictates which form the employer must fill out when setting up the SIMPLE IRA.

Employers can sometimes receive benefits or other advantages from signing up all their employees with the same financial institution.

It may be beneficial to research different institutions if you are an employer looking to set up a SIMPLE IRA for your employees.

However, employees may have financial institutions that they already have IRAs with. In this case, allowing employees to choose may be a better idea.

#2. Select Type of SIMPLE IRA

If you’ve decided to let your employees choose which financial institution will hold their IRAs, you’ll need to fill out the IRS (Internal Revenue Service) Form 5304-SIMPLE.

In contrast, you’ll need to fill out the IRS Form 5305-SIMPLE if you plan to choose the financial institution for all of your employees’ IRA accounts.

Once this is done, be prepared to fill out tons of SIMPLE IRA adoption agreements. Employees must fill these out individually to open an account and begin making contributions.

#3. Repeat for Each Employee

Once all this is done, and your paperwork is approved, you just need to repeat the process for every new employee.

Have them fill out the above SIMPLE IRA adoption agreement, and you will gradually bring everyone into the fold.

SIMPLE IRA Contribution Limits

With SIMPLE IRAs, employees are limited to annual contributions of $13,500. Note that this maximum periodically increases to account for market inflation.

Furthermore, any employees aged 50 or older can make extra annual contributions up to $3000. This allows for a maximum contribution amount of $16,500 per year.


Setting up a SIMPLE IRA is no small deal. Remember that all employers who run a SIMPLE IRA must contribute to it every year until the plan is eventually terminated or the business closes. Furthermore, employers must either contribute:

  • the mandatory 2% contribution of an employee’s salary to that employee’s IRA
  • a “dollar-for-dollar” matching contribution of up to 3% of an employee’s salary

For instance, employers may be required to match $2000 per year if an employee’s salary is $100,000 per year.

Alternatively, they may match $3000 per year if the employee in question also contributed $3000 with a salary of $100,000 to start with.

Benefits of a SIMPLE IRA

  • Employers can benefit from setting up a SIMPLE IRA since there are fewer startup and operating costs compared to traditional 401(k) plans
  • Furthermore, employers can benefit from tax deductions by deducting each contribution they make to their employees’ accounts
  • Employees benefit from converting to SIMPLE IRAs as well. For starters, since employers must contribute to employee SIMPLE accounts, this means that any wealth within those accounts will grow exponentially faster compared to traditional IRAs, which are only contributed to by account holders
  • Employees never have to sign up for any salary deferrals or reductions to get the non-elective 2% employer contribution
  • It’s typically easy to qualify for a SIMPLE IRA. In most cases, employees that received at least $5000 in earnings during the last two calendar years, and employees who expect to earn at least that must during the current year, will qualify for SIMPLE IRAs
  • Even if employees don’t meet the above qualifications, the IRS typically allows employers to offer SIMPLE IRA qualification to employees anyway
  • Employees can contribute to additional retirement savings plans, such as traditional or Roth IRAs, at the same time
  • Any employer contributions vest immediately. Basically, this means that employees have 100% access and ownership to the money inside a SIMPLE IRA once it arrives
  • Employees who choose their own investment institutions can benefit from greater investment flux ability and choices compared to 401(k) plans

Downsides of a SIMPLE IRA

  • Compared to either 401(k) plans or SEPs (simplified employee pensions), business owners typically do not save as much for retirement. In this way, SIMPLE IRAs are great for employees but less advantageous for their employers
  • SIMPLE IRAs cannot be rolled over into traditional IRAs unless they try to roll their account over and wait for two years. This contrasts with a 401(k), which usually allows instantaneous transfer or rollover

Alternatives to SIMPLE IRAs

SIMPLE IRAs can be effective financial savings instruments for employers and employees. But both 401(k)s and SEP-IRA plans are strong alternatives as well.

An employer can offer a 401(k) plan and decide whether they want to match any employee contributions.

401(k) plans are basic retirement accounts that employees can contribute to a set limit. Employers typically choose to match contributions up to a certain dollar amount or percentage of employee paycheck.

On the other hand, a SEP-IRA only has employers contribute to retirement on behalf of their employees. This is typically up to 25% of any employee’s salary each year up to a total amount of $57,000 per year.

SEP-IRAs may be better for small businesses or family businesses where employers can more reliably take charge of employee savings.

Ultimately, it’s up to you to decide whether a SIMPLE IRA is a good choice for your business and employees. Be sure to consider your investment options carefully before deciding.

Bottom Line: SIMPLE IRAs

SIMPLE IRAs are beneficial for employees as they allow them to save for retirement.

All things considered, this option is ideal for small business owners and startups. As an employer and leader, it is your fiduciary duty to research all options before committing.

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Kim Pinnelli
Kim Pinnelli

Kim Pinnelli is a Senior Writer, Editor, & Product Analyst with a Bachelor’s Degree in Finance from the University of Illinois at Chicago. She has been a professional financial writer for over 15 years, and has appeared in a myriad of industry leading financial media outlets. Leveraging her personal experience, Kim is committed to helping people take charge of their personal finances and make simple financial decisions.