What Is a Simple 401(k)?

A traditional 401(k) plan plays an important role in retirement planning for many Americans, helping them save and invest for their future. For small businesses, though, offering regular 401(k) plans to employees can be expensive and complex. 

To solve this problem, the IRS allows small businesses to establish SIMPLE 401(k) plans for their employees. However, while these plans are meant to act as a replacement savings vehicle for small business employees who otherwise don’t have access to a traditional 401(k), there are some important differences between the two.

What is a Simple 401(k)?

A Savings Incentive Match Plan for Employees, or SIMPLE 401(k), is a type of retirement savings plan available to small businesses with 100 or fewer employees. Because these plans are not subject to many of the same IRS non-discrimination tests as traditional plans, and involve lower administration costs, small businesses are more likely to be able to offer and manage them. 

For employees, A SIMPLE 401(k) can work similarly to standard 401(k) plans: Elective contributions can be made by the employee, using pretax dollars that are directed from their paycheck. 

For employers, things work a little differently. Employers are required to contribute to each eligible employee’s SIMPLE 401(k) plan, as either a:

• Dollar-for-dollar match on employee contributions up to 3% of the employee’s pay 
• A non-elective contribution of 2% of each eligible employee’s pay

Employees are not required to contribute in order to receive contributions from their employer. 

Funds contributed to an employee’s SIMPLE 401(k) are then invested in the plan options offered by the employer, where they have the opportunity to grow over time. Management fees for these savings vary according to the plan’s administrator and the investments themselves. Employees are 100% vested in their plan funds—including those contributed by their employer—from day one.

Once the employee reaches retirement (at least age 59 ½), they can begin taking withdrawals from their SIMPLE 401(k) savings. Since contributions to this account were made with pretax dollars—and grew tax-free over the years—these future distributions are subject to income tax in the year they’re withdrawn.

SIMPLE 401(k) eligibility

A SIMPLE 401(k) retirement plan can only be provided by small businesses with 100 or fewer employees. Businesses offering a SIMPLE 401(k) plan to employees cannot offer another retirement plan to those same employees.

In order for an employee to qualify for the SIMPLE 401(k) plan, they will need to earn at least $5,000 per year from the company. Eligibility is based on the preceding year’s income, and whether the employee can expect to earn at least $5,000 in the upcoming year.

Businesses can also elect to add other eligibility requirements for employees, such as being 21 and/or performing at least one year of service for the company. One year is the maximum length of service a business can require as a condition of their SIMPLE 401(k) participation.

SIMPLE 401(k) contributions and withdrawals

As with traditional401(k) accounts, SIMPLE 401(k) plan participants have annual contribution limits. 

For 2022, the maximum employee contribution limit for a SIMPLE 401(k) is $14,000. For 2021, the limit was $13,500.

If the employee is 50 or older, an additional catch-up contribution of $3,000 is allowed. This means that for 2022, a 50+ employee can put as much as $17,000 from their workplace earnings into their employer-sponsored SIMPLE 401(k) account.

Once the employee reaches age 59 ½ (or older), they can elect to take distributions from the SIMPLE 401(k) account without penalty. These withdrawals are subject to income tax, according to the individual’s overall tax bracket. 

Early withdrawals from a SIMPLE 401(k) are subject to the same 10% penalty that applies to traditional 401(k) accounts. This is in addition to any income taxes due on the funds.

SIMPLE vs. Traditional 401(k)

Though a traditional and SIMPLE 401(k) behave similarly and follow many of the same IRS rules, there are still some key differences between the two accounts.

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SIMPLE 401(k) vs. SIMPLE IRA 

Both SIMPLE 401(k) and SIMPLE IRA plans are available to eligible employees of small businesses, such as those with 100 or fewer employees. But there are differences between SIMPLE 401(k)s and IRAs—namely in who makes investment choices and the option to take a loan against the funds.

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Potential advantages of SIMPLE 401(k) plans

Considering a SIMPLE 401(k) offered by an employer? Here’s a look at some of the advantages of using this type of retirement account. 

• Employer contributions of 2% or 3% are required
• Employees are fully vested in all contributions immediately
• Loans are allowed

Potential limitations of SIMPLE 401(k) plans

There are a few drawbacks to keep in mind with Simple 401(k) plans. 

• Contribution limits are lower than those of traditional 401(k) plans
• Employers cannot offer other retirement plans to an employee if they offer a SIMPLE 401(k)

The bottom line

Small businesses may find traditional 401(k) plans to be cost-prohibitive and cumbersome to manage, especially if they have 100 or fewer employees. A SIMPLE 401(k) can be a manageable alternative, offering employees a way to save for their retirement.

Companies are required to contribute to their employees’ SIMPLE 401(k) plans, and employees are 100% vested in the contributions immediately. However, contribution limits are lower than those of traditional 401(k) plans, so future retirees will need to plan their savings accordingly.