A SIMPLE IRA plan is similar to a Solo 401(k) Plan in that it is funded by employee deferrals and additional employer contributions. However, unlike a Solo 401(k) Plan, a SIMPLE IRA plan uses an IRA-type trust to hold contributions for each employee, rather than a single plan trust that is typical of a traditional employer 401(k) Plan. A SIMPLE IRA can be opened with a bank, insurance company or other qualified financial institution. However, unlike a Solo 401(k) Plan, the employee owns and controls the SIMPLE IRA.
A SIMPLE IRA plan can be established by any employer who has less than 100 employees, who will receive at least $5,000 in compensation from the employer in the proceeding calendar year. The SIMPLE IRA plan has a lower deferral limit than a Solo 401(k) Plan. However, unlike a Solo 401(k) Plan, the SIMPLE IRA plan uses an IRA-style trust to hold SIMPLE IRA contributions for each employee, rather than the a single plan like a 401(k) Plan or other qualified retirement plan.
Solo 401(k) Plan
A Solo 401(k) Plan is an IRS approved retirement plan, which is suited for business owners who do not have any employees, other than themselves and perhaps their spouse. The “one-participant 401(k) Plan” or individual 401(k) Plan is not a new type of plan. It is a traditional 401(k) Plan covering only one employee. Before the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) became effective in 2002, there was no compelling reason for an owner-only business to establish a Solo 401(k) Plan because the business owner could generally receive the same benefits by adopting a profit sharing plan or a SEP IRA. After 2002, EGTRRA paved the way for an owner only business to put more money aside for retirement and to operate a more cost-effective retirement plan than the SEP IRA or SIMPLE 401(k) Plan.
There are a number of options that are specific to Solo 401(k) Plans that make the Solo 401k plan a far more attractive retirement option for a self-employed individual than a SIMPLE IRA.
1. Higher Contributions: A Solo 401(k) Plan includes both an employee and profit sharing contribution option, whereas, a SIMPLE IRA only offers minimal employee deferral opportunities.
Under the 2017 Solo 401(k) contribution rules, a plan participant under the age of 50 can make a maximum employee deferral contribution in the amount of $18,000. That amount can be made in pre-tax or after-tax (Roth). On the profit sharing side, the business can make a 25% (20% in the case of a sole proprietorship or single member LLC) profit sharing contribution up to a combined maximum, including the employee deferral, of $54,000.
For plan participants over the age of 50, an individual can make a maximum employee deferral contribution in the amount of $24,000. That amount can be made in pre-tax or after-tax (Roth). On the profit sharing side, the business can make a 25% (20% in the case of a sole proprietorship or single member LLC) profit sharing contribution up to a combined maximum, including the employee deferral, of $60,000.
Whereas, a SIMPLE IRA has a lower deferral limit of $11,500 for 2017, plus a $2,500 catch-up contribution. In addition, the employer must provide either a dollar-for-dollar contribution of up to three percent of compensation to all who defer or a two percent non-elective contribution to all employees who are eligible to participate in the plan and who have earned $5,000 or more in compensation from the employer during the year.
Hence, a participant in a SIMPLE IRA would be significantly limited in the amount of annual deferrals to be made to the retirement account in comparison to a Solo 401(k) Plan participant.
2. Reduced Catch-Up Contribution amount: With a Solo 401(k) Plan, for 2017, a plan participant who is over the age of 50 is able to make a catch-up contribution of up to $6,000. Whereas, with a SIMPLE IRA, the maximum annual contribution limit for 2017 is just $2,500.
3. No Roth Feature: A Solo 401(k) Plan can be made in pre-tax or Roth (after-tax) format. Whereas, in the case of a SIMPLE IRA, contributions can only be made in pre-tax format. In addition, a contribution of $18,000 ($24,00, if the plan participant is over the age of 50) can be made to a Solo 401(k) Roth account.
4. Tax-Free Loan Option: With a Solo 401(k) Plan you can borrow up to $50,000 or 50% of your account value, whichever is less. The loan can be used for any purpose. With SIMPLE IRA, the IRA holder is not permitted to borrow even one dollar from the SIMPLE IRA without triggering a prohibited transaction.
5. Use Nonrecourse Leverage and Pay No Tax: With a Solo 401(k) Plan, you can make a real estate investment using nonrecourse funds without triggering the Unrelated Debt Financed Income Rules and the Unrelated Business Taxable Income (UBTI or UBIT) tax (IRC 514). However, the nonrecourse leverage exception found in IRC 514 is only applicable to 401(k) qualified retirement plans and does not apply to IRAs. In other words, using a Self-Directed SIMPLE IRA to make a real estate investment (Self Directed Real Estate IRA) involving nonrecourse financing would trigger the UBTI tax.
5. Open the Account at Any Local Bank: With a Solo 401(k) Plan, the 401k bank account can be opened at any local bank or trust company. However, in the case of a SIMPLE IRA or a Self-Directed IRA, a special IRA custodian is required to hold the IRA funds.
6. No Need for the Cost of an LLC: With a Solo 401(k) Plan, the plan itself can make real estate and other investments without the need for an LLC, which depending on the state of formation could prove costly. Since a 401(k) Plan is a trust, the trustee on behalf of the trust can take title to a real estate asset without the need for an LLC.
7. Better Creditor Protection: In general, a Solo 401(k) Plan offers greater creditor protection than a SIMPLE IRA. The 2005 Bankruptcy Act generally protects all 401(k) Plan assets from creditor attack in a bankruptcy proceeding. In addition, most states offer greater creditor protection to a Solo 401(k) qualified retirement plan than a SIMPLE IRA outside of bankruptcy.
The Solo 401(k) Plan is unique and so popular because it is designed explicitly for small, owner-only businesses. The many features of the Solo 401(k) Plan discussed above are why the Solo 401(k) Plan or Individual 401(k) Plan is so appealing and popular among self-employed business owners.
To learn more about the benefits of a Solo 401(k) Plan vs. a SIMPLE IRA, please contact a tax professional at 800-472-0646.