What Is a 401(k)?

A traditional 401(k) is a retirement plan an employer offers.

The 401(k) plan is an excellent option for employees to save money in tax-deferred accounts. The employee does not have to pay federal income taxes on any funds they invest, and you will only pay ordinary income taxes on your withdrawals when taking out these funds.

For instance, you save $6,000 into your 401(k) for over a year. This $6,000 will be deducted from your income taxes for that specific year. You can withdraw it as needed and pay taxes on withdrawals based on your state and federal income tax brackets.

In 2022, the contribution limit for 401(k)s is $20,500 (up from the $19,500 limit in 2021). Catch-up contribution for those over 50 remains $6,500. In 2023, the contribution limit is $22,500 with a catch-up contribution of $7,500 for those 50 or older.

Another key feature of 401(k) is that employers can match their employees' contributions. For example, your employer may match 50% of your contributions up to 5% of your total salary.

However, matching contributions made by employers do not count toward the contribution limit. The 2022 limit for combined contributions made by employers and employees is $61,000 or $67,500 for employees age 50 and older. For 2023 the combined limit is $66,000 and $73,500 respectively.

What Is a SIMPLE IRA?

A SIMPLE IRA,  which stands for “Savings Incentive Match Plan for Employees,” is a type of tax-deferred retirement savings plan that most small businesses with 100 or fewer employees can use.

SIMPLE IRAs’ appeal is that they require minimal paperwork and have low costs. Employers also receive a tax deduction for the contributions they make for employees.

To participate, employees must make at least $5,000 annually. Regular employees can contribute up to $14,000 for the 2022 tax year, or $17,000 for employees who are 50 and up. In 2023, the employee contribution limit is $15,500 or $19,000 for those 50 and over.

Employers are required to make yearly contributions, but the contributions are tax-deductible. They can choose to match the SIMPLE IRA contributions up to 3% or contribute 2% of the employee's salary up to the total contribution limit, which is $305,000 in 2022 (or $330,000 in 2023).

401(k) vs. SIMPLE IRA: The Differences

Fundamental to the SIMPLE IRA vs. 401(k) decision is choosing between flexibility and simplicity for employers.

When evaluating a 401(k) vs. SIMPLE IRA retirement plan option, it is crucial to note their differences. This way, you, as an individual, can choose the type of account that best suits your personal needs.

Source: https://www.irs.gov/

The Pros and Cons

SIMPLE IRA Pros

• Participants may be allowed to choose an account provider

• Requires minimum administrative management

• Setup and maintenance costs are lower

SIMPLE IRA Cons

• Compulsory employer contribution

• No available Roth 401(k) option

• Contribution limits are lower

• No loans allowed

• Employers are prohibited from maintaining any other type of retirement plan.

401(k) Pros

• Employers are not obligated to make matching contributions

• Available Roth 401(k) option

• Contribution limits are higher

• The employer sets the vesting schedule

• The plan may allow loans

401(k) Cons

• Setup costs and administrative requirements are higher

• Plan fees for small businesses can be high

Factors to Consider in Deciding Which Option is the Best

Retirement savings plans can be a great way to save for retirement, but there are some things to consider. To help decide between SIMPLE IRA and a 401(k), you need to consider the following factors:

Purpose of Setting up a Retirement Plan

Many small business owners max out their retirement savings dollars. If you are one of these people, contribution limits will likely affect your decision. But for high earners, the higher contribution limit of the 401(k) is a better choice than a SIMPLE IRA.

Importance of Roth Option

The Roth 401(k) option is another important factor you should consider when choosing between SIMPLE IRA and 401 (k).

As mentioned above, SIMPLE IRA has no Roth option. Like other types, contributions reduce your tax liability for that year, but withdrawals in retirement are taxed as ordinary income. However, participants can simultaneously save in both SIMPLE IRA and Roth IRA plans.

Employer Contributions Adjustments

Employer contributions are not compulsory for companies that offer 401(k) plans. However, the employer may choose to contribute a certain percentage of your salary each pay period.

Vesting terms allow employers to require employees to remain employed for a specific number of years before taking full ownership of matching contributions.

In a SIMPLE IRA, employer contributions are compulsory; however, you can choose between two matching arrangements stated by the IRS.

The Bottom Line

The SIMPLE IRA and the traditional 401(k) plans are two great ways to save for retirement. The SIMPLE IRA plan is great for companies that want to offer tax-advantaged retirement plans without administrative hassles.

However, if you are an individual who wants to maximize contribution limits and grow their assets faster in retirement, it is best to go with a traditional 401(k).

It is essential to consult a financial adviser who can review your retirement goals and help you choose the retirement plan that best suits your needs.

FAQs

1. What is a 401(k) retirement plan?

The 401(k) plan was created to help employees save for their future. It is meant to act as a supplement to existing plans, or as an alternative. This plan offers a non-complicated set up and is simple to maintain and understand. It is up to the employer to make sure employees are participating in a 401(k) plan.

2. What is a SIMPLE IRA retirement plan?

A SIMPLE IRA is a type of retirement plan designed to help small companies and the self-employed save for retirement.

3. What is the difference between both accounts?

There are several areas where SIMPLE IRA and 401(k) plans vary. A SIMPLE IRA has lower administration costs and a more straightforward reporting system, thus requiring more work from the employer. However, a 401(k) offers beneficial taxation that is preferable to many individuals looking for retirement savings.

4. How much are the yearly contribution limits for SIMPLE IRA and 401(k) plans?

For a SIMPLE IRA, the 2023 contribution limit is $15,500 or $19,000 if over 50 years old. On the other hand, 401(k) allows individual employees up to $22,500 in contributions per year for individuals younger than 50 and $30,000 for those over 50 years old.

5. Which account is better?

It is easy to compare the SIMPLE IRA and 401(k) plans if you consider their yearly contribution limits, eligibility requirements, and administration. Your final decision should be to find out the best fit for your lifestyle and financial goals.