SIMPLE IRA vs. 401(k): Which Fits Your Small Business?

A SIMPLE IRA is generally better than a 401(k) for most small businesses with fewer than about 25 employees. A SIMPLE IRA costs a fraction as much, doesn't require any Form 5500 filings and isn't subject to any nondiscrimination testing. The 401(k) wins on limits: an employee may defer roughly 40% more, and the overall-contribution ceilings under the 401(k) when combined with profit-sharing contributions will exceed those of the SIMPLE deferral limit by multiple times. Many small business looking for a "401(k)" would be far better off in a SIMPLE IRA and most SIMPLE IRA plan sponsors will eventually grow into a 401(k). Here's how this really compares.

Where does the SIMPLE IRA win?

The SIMPLE IRA wins on administration and cost, and this difference isn't a matter of finding the right vendor, it's structural.^[1] Every year a 401(k) sponsor pays for something that really exists: a recordkeeper, a third-party administrator or bundled services company, and often asset based fees skimmed off employees' account balances. Every year a SIMPLE IRA sponsor has to pay for custody services, run payroll deferrals, and meet a handful of deadlines. If you're new to the plan type, begin by reading What Is a SIMPLE IRA?

Here is the side-by-side:

Where does the 401(k) win?

In terms of room and flexibility, the 401(k) is far superior to the SIMPLE IRA. An employee may defer roughly 40% more than they could have contributed under the SIMPLE IRA limits with regard to deferred compensation. Additionally, total contributions, including those made through a profit-sharing plan, may reach a ceiling several times the maximum amount that can be deferred under a SIMPLE IRA. Both Roth provisions and loan options are available in addition to vesting schedule provisions, none of which exist within the framework of a SIMPLE IRA. It is this last provision that will greatly influence retention efforts since an employer match contribution into a 401(k) plan can vest out over time whereas all contributions to a SIMPLE IRA belong to the employee immediately and cannot be forfeited due to some future event or circumstance.^[1]

Highly-compensated business owners will typically be able to shelter significantly more income from taxes within a 401(k) once their business can fund its administrative costs. For this reason, owner-heavy firms with good cash flow sometimes elect to bypass the SIMPLE IRA phase altogether.

How does a mid-year SIMPLE IRA to 401(k) conversion work?

With SECURE 2.0 (§332), a business can now terminate a SIMPLE IRA mid-year and establish a safe-harbor 401(k) instead. Previously the exclusive-plan rule required you to run the SIMPLE IRA through December 31 and start the 401(k) on January 1. This means companies will no longer be required to sit in the wrong plan for most of a year as they grow or need changes. The switch will now occur once your company is prepared for such a transition.

Deferrals in both plans during the same year are coordinated under a combined limit. In this case, time the transition with whoever administers the new plan. There's one caveat for employees: a rollover from an employee SIMPLE IRA into the new 401(k) cannot occur until two years have passed on that SIMPLE IRA account, and moving it sooner triggers a 25% penalty when you try to do it rather than the 10% you would normally expect.^[2] The change makes the SIMPLE IRA an actual starter plan (versus a trap) as you can now use it at little cost while keeping open the option of exiting later.

Which plan should you choose?

In most cases for an employer with less than approximately 25 employees and no owner who will exceed the SIMPLE deferral limits, a SIMPLE plan is going to be your best bet in terms of overall cost vs. complexity. A SIMPLE plan eliminates loan options, profit-sharing plans and vesting schedules. However most employers under 25 do not utilize these benefits anyway, and as time passes (years) the savings are compounded by using a simpler plan that costs less each year. There is one other rarely used alternative available to some employers, the SIMPLE 401(k), but if you elect this alternative, it has all of the paperwork associated with the 401(k) filing requirements at the lower SIMPLE deferral limit. Therefore this option generally does not beat out either choice.

When there are about 25 to 30 employees, or owners want to defer more than the SIMPLE contribution limits will permit, the 401(k)'s higher contribution limits begin to justify its cost and testing. Growth also brings the participation and payroll complexity that a 401(k) can handle. If you're an owner-only business evaluating employer funded options, go to SEP IRA vs. SIMPLE IRA.

Both plans meet state auto-IRA mandates like CalSavers. Ongoing obligations of the SIMPLE IRA are set out in SIMPLE IRA Rules for Employers.

The Bottom Line

A SIMPLE IRA uses payroll deferrals, just like a 401(k), however a SIMPLE IRA skips Form 5500, nondiscrimination testing, and audit exposure at a fraction of the cost. On the other hand, the 401(k) provides about 40% higher deferrals, plus profit sharing, loans, and vesting. Therefore under approximately 25 employees the SIMPLE IRA usually wins. Additionally, SECURE 2.0 lets an employer convert during the middle of the year once the math flips.

This guide is educational and summarizes IRS rules for SIMPLE IRA plans. It is not investment, legal, or tax advice. Your plan documents and current IRS limits control. Talk to your tax advisor about your business's circumstances.