SIMPLE 401(k) Plan: What It Is, How It Works, FAQ

What Is a SIMPLE 401(k) Plan?

A SIMPLE 401(k) is a retirement savings account offered by small business employers with 100 or fewer employees. The SIMPLE 401(k) works just like a regular 401(k) plan, combining it with the simplicity of a SIMPLE IRA with a few minor changes. Employees can defer some of their wages to the plan and employers must either make a matching or non-elective contribution of a certain amount of each employee's wages.

Employers who are eligible to set up these plans must meet certain eligibility requirements and the Internal Revenue Service (IRS) sets limits on how much can be contributed each year.

How SIMPLE 401(k) Plans Works

As the name implies, the SIMPLE 401(k) is a simplified, stripped-down version of a regular 401(k) plan that is geared toward self-employed individuals and small business owners. And just like SIMPLE IRA accounts, only employers with a staff of 100 or fewer can establish SIMPLE 401(k) plans. Establishing businesses can be structured in any form, including sole proprietors, corporations, and partnerships.

SIMPLE 401(k)s work just like regular 401(k)s. Employees contribute with pre-tax dollars out of their paychecks, investing the funds in options provided by the plan administrator. The IRS limits annual contribution amounts, which are about two-thirds of those allowed for regular 401(k)s. Employees can contribute a maximum of $15,500 in 2023 and $16,000 in 2024. People 50 and over are allowed to deposit an additional catch-up contribution of $3,500 in 2023 and 2024.

All employer contributions to a SIMPLE 401(k) are subject to an employee compensation cap, which is $330,000 for 2023 and $345,000 for 2024. This is one way the SIMPLE 401(k) differs from a SIMPLE IRA. Unlike traditional 401(k)s, employers are required to make either a matching contribution to their employees' accounts—up to 3% of each employee's pay or a nonelective contribution of 2% of each eligible employee's pay.

SIMPLE 401(k) Rules and Regulations

Employees who are at least 21 years old and completed at least one year of service must be allowed to participate in their employers' SIMPLE 401(k) plans. They must also receive at least $5,000 in SIMPLE compensation from their employers for the preceding year in order to take part.

Funds in a SIMPLE 401(k) must be held in the account until the employee reaches age 59½. Withdrawals made before that point are subject to an early withdrawal penalty of 10%.

The employer must provide a deferral notice to each eligible employee for the year the plan is established and for each year the employer continues to maintain the plan. This notification must be provided at least 60 days before the employee becomes eligible to participate. It must include a statement of the employee's right to make salary deferral contributions and to terminate their participation in the plan.

Advantages and Disadvantages of SIMPLE 401(k)s

There are a number of different benefits to participating in a SIMPLE 401(k) plan. But there are also several drawbacks. We've noted some of the major ones below.

Advantages

Contributions to a SIMPLE 401(k) are immediately 100% vested. An employee who meets the requirements to receive distributions from the plan may withdraw their entire account balance whenever they like and won't lose it if they switch jobs after the money is in their account.

One of the simplified features is that SIMPLE 401(k) plans do not require nondiscrimination and top-heavy testing to ensure that the plan operates in compliance with IRS rules. Such testing must generally be done by professionals and can be quite costly.

Although withdrawals before the age of 59½ are subject to a penalty, employees can take out loans against their SIMPLE 401(k) balances. They also have the option of making hardship withdrawals from their plans if they need to do so.

Disadvantages

Unlike other retirement options, employer contributions are mandatory for those who offer SIMPLE 401(k) plans to their employees. As noted above, employers have one of two options available. They can contribute either 3% of each employee's pay or they can make nonelective contributions of 2% of each eligible worker's salary.

IRS rules prohibit a company from offering other types of retirement plans to employees already covered by a SIMPLE 401(k). That said, these companies may choose to maintain a separate retirement plan for other employees not covered by the SIMPLE 401(k).

Contribution caps to SIMPLE 401(k)s are smaller than those for traditional 401(k) plans. As noted earlier, employees can only contribute $15,500 in 2023 to a SIMPLE 401(k) plan with catch-up contributions of $3,500 per year for those 50 and older. Though these amounts increased to $16,000 of contributions with the same catch-up of $3,500 in 2024, these amounts are still lower than other retirement plans. For example, taxpayers can set aside $22,500 to their 401(k)s in 2023 and $23,000 in 2024. Catch-up contributions for these plans are $7,500 in both 2023 and 2024.

The Bottom Line

Helping your employees save for retirement is a great way to keep turnover rates down and retention up. It doesn't hurt in attracting talent, either—keeping a small firm competitive with the perks offered by larger corporations.

While SIMPLE 401(k) plans have a lot of benefits, such as easy-to-manage rules, they do have some disadvantages when compared with other savings plans. The mandatory contributions and the paperwork, simplified though it is, can be a burden.

As a result, they're not for every company but then, few options are. Consult with 401(k) plan providers and your team of tax professionals to see if this retirement vehicle is the best suited for you and your staff.