Is a SIMPLE IRA the same as a traditional IRA?

If you are self-employed, you have several retirement plans to choose from, including a SIMPLE IRA and a traditional IRA. Both retirement plans allow retirement savers to defer paying taxes on retirement contributions and investment earnings, but certain differences set them apart.

A SIMPLE IRA is not the same as a traditional IRA, but both retirement plans have certain similarities and differences. Both SIMPLE IRA and traditional IRA allow retirement savers to contribute pre-tax money to their retirement account. However, a SIMPLE IRA is funded by both employer and employee contributions, while a traditional IRA is only funded by the account owner’s contributions.

SIMPLE IRA Explained

A SIMPLE IRA is set up by small business owners to help both the employer and the employees save for retirement. This retirement plan is available to small businesses with up to 100 employees. Employers may be eligible to participate in the SIMPLE IRA if they earned at least $5,000 during the last two years, and expect to make a similar amount or more in the current year.

A SIMPLE IRA shares certain similarities with a traditional IRA. One of these similarities is that account holders can make pre-tax contributions to their retirement account. This means you won’t pay tax when you contribute to the account. The money will grow tax-deferred, and you will only pay tax when you take a distribution from the account. Once you reach 72, you must take the required minimum distributions (RMDs) from the SIMPLE IRA.

Unlike a traditional IRA that is funded by the account owner only, a SIMPLE IRA receives contributions from both the employer and the employee. The employer can match employee contributions at the rate of 1% to 3% of salary, or make a flat contribution of 2% of each employee’s salary.

Traditional IRA Explained

If you have an earned income in the tax year, you can open a traditional IRA account and contribute to retirement. An IRA allows individuals to contribute pre-tax money to the account, and get an immediate tax break. Once you contribute to an IRA, you can invest the IRA funds in a wide pool of investment options that comprise stocks, bonds, mutual funds, tax deeds, etc.

The funds deposited in an IRA grow tax-deferred over the years until you take a distribution. If you are below 59 ½ at the time of distribution, you will pay a 10% penalty and ordinary income tax on the withdrawal.  However, certain withdrawals may qualify for an exemption on the early withdrawal penalty. If you are 59 ½ or older at the time of distribution, you will only pay income taxes on the money. Once you attain age 72, you must take RMDs from the IRA.

Simple IRA vs. Traditional IRA: How do they compare?

Contribution limit

One of the differences between these retirement plans is the annual contribution limit. The contribution limit for a SIMPLE IRA is $14,000 in 2022 or $13,500 in 2021, and employees above 50 can contribute an extra $3,000 in catch-up contribution. A traditional IRA has a lower contribution limit than a SIMPLE IRA, and you can contribute up to $6,000 to an IRA in 2022 and 2021, and an additional $1,000 if you are above 50.

Employer contributions

An employer is required to contribute to a SIMPLE IRA, either as a flat employer contribution or matched contributions. An employer can make matching contributions of 1% to 3% of the employee’s compensation, or make a flat contribution of 2% of the employee’s salary. In comparison, a traditional IRA is not funded with employer contributions.

Early withdrawals

Early withdrawals from a SIMPLE IRA and a traditional IRA could attract early withdrawal penalties, but a SIMPLE IRA could have harsher penalties. If you withdraw money from a SIMPLE IRA in the first two years of plan participation, you could pay up to 25% in early withdrawal penalties, in addition to income taxes. In comparison, early withdrawals from a traditional IRA attract a 10% early withdrawal penalty.

Can I have a SIMPLE IRA and a traditional IRA?

You can have a SIMPLE IRA and a traditional IRA at the same time. You can have a SIMPLE IRA through your employer and still open a traditional IRA with a financial institution or brokerage. However, you may not qualify to take a full tax deduction on all your IRA contributions in the tax year.

Since a SIMPLE IRA has a higher contribution, you can sock away more money for your retirement, and still receive an employer match on your contributions. If you are the employer, you can contribute to the SIMPLE IRA both as an employer and employee. Once you max out your contributions, you can direct the surplus cash to a traditional IRA to help you accumulate more money for your retirement.