A 401(k) plan and an individual retirement plan (IRA) are similar in many ways. Both allow you to make elective contributions from your salary that are excluded from your taxable income and both provide the opportunity for employers to match employee contributions. These two types of retirement plans also have several key differences, especially in the area of maximum contributions. Understanding these differences will help you make the right choices for your situation as either an employee or employer.
What Is a SIMPLE IRA?
The SIMPLE IRA, short for Savings Incentive Match Plan for Employees, is a retirement plan designed to be easier to start and manage for small businesses and self-employed individuals than a 401(k) plan. The IRS limits SIMPLE IRA plans to employers with fewer than 100 employees who don’t offer some other retirement plan. Employees who receive $5,000 or more in compensation from the employer during any two previous years and who are expected to receive at least $5,000 during the current year are eligible to participate in the plan. An employer is allowed to use less restrictive participation requirements, but not more restrictive.
Comparing SIMPLE IRA and 401(k) Plans
Unlike the SIMPLE IRA, which is limited to small businesses, public and private companies of any size can set up a 401(k). With a 401(k), employers are not required to make contributions, although many employers elect to make some type of matching contribution for participating employees. In contrast, the SIMPLE IRA requires employers to contribute either a fixed 2 percent of all employees’ compensation or match up to 3 percent of employee compensation. Another important difference between these two types of plans is that employees cannot borrow money from their SIMPLE IRA accounts, while they can from 401(k) plans.
Differences in Plan Investment Options
The differences between SIMPLA IRA and 401(k) plans extend to investment options. The employer chooses the financial institution that will invest the funds from a SIMPLE IRA, and employees are then free to move their money to different investment options – stocks, mutual funds, bonds or real estate – and control the investment mix. With 401(k) plans, employees can choose from mutual funds rather than from individual stocks and bonds. Mutual funds represent the contributions of many investors that are pooled and used to purchase securities like stocks, bonds and short-term debt.
Comparing Plan Contribution Limits
In 2019, employees can contribute up to $13,000 from their annual salary to an employee-sponsored SIMPLE IRA. In contrast, the limit on employee 401(k) annual contributions is $19,000. Employees above age 50 are allowed to make up to $6,000 in catch-up contributions to a 401(k) account. The limit for SIMPLE IRA accounts is $3,000. For both types of plans, employers may impose lower limits for employee contributions as part of the plan terms.
Catie Watson spent three decades in the corporate world before becoming a freelance writer. She has an English degree from UC Berkeley and specializes in topics related to personal finance, careers and business.