A SIMPLE IRA plan is similar to a Solo 401k Plan in that it is funded by employee deferrals and additional employer contributions. However, unlike a Solo 401k 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 401k Plan, the employee owns and controls the SIMPLE IRA.
Since 2001, the Solo 401(k) plan has overtaken the SIMPLE IRA as the most popular retirement plan for the self-employed or small business with no full-time employees (over 1,000 hours or three consecutive years of 500 hours). This article will examine the reasons why the Solo 401(k) plan is so much more popular than 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 a single plan like a 401(k) Plan or other qualified retirement plan. For example, each employee of a business that adopted a SIMPLE IRA can have their own SIMPLE IRA account, which offers the SIMPLE IRA participant far greater investment options.
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 401k 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.
Solo 401(k) vs. SIMPLE IRA
There are a number of options that are specific to Solo 401(k) plans that make it 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 Solo 401(k) contribution rules, in 2023, a plan participant under the age of 50 can make a maximum employee deferral contribution in the amount of $22,500. That amount can be made in pretax 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 $66,000 ($61,000 for 2022).
For 2023, plan participants over the age of 50, an individual can make a maximum employee deferral contribution in the amount of $30,000. That amount can be made in pretax 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 $73,500 ($67,500 for 2022).
Whereas, a SIMPLE IRA has a lower deferral limit of $15,500 for 2023 ($14,000 for 2022), plus a $3,500 catch-up contribution ($3,000 for 2022). 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 number of annual deferrals to be made to the retirement account in comparison to a Plan participant.
2. Reduced Catch-Up Contribution amount
With a Solo 401(k) plan, for 2023, a plan participant who is at least age 50 is able to make a catch-up contribution of up to $7,500 ($6,500 for 2022). Whereas, with a SIMPLE IRA, the maximum annual contribution limit for 2023 is just $3,500 ($3,000 for 2022).
3. No Roth Feature
In 2023, a Solo 401(k) plan can be made in pretax or Roth (after-tax) format. Whereas, in the case of a SIMPLE IRA, contributions can only be made in pretax format. In addition, a contribution of $22,500 ($30,000, if the plan participant is over the age of 50) can be made to a Roth account.
4. Tax-Free Loan Option
With a Solo 401(k) plan, a plan participant can borrow up to $50,000 or 50% of your account value, whichever is less. The loan can be used for any purpose but must be paid back over a five-year period using a minimum interest rate of Prime. 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 Non-recourse Leverage and Pay No Tax
With a Solo 401(k) Plan, a plan participant can make a real estate investment using a non-recourse loan (a loan not personally guaranteed by the plan participant) without triggering the Unrelated Debt Financed Income Rules and the Unrelated Business Taxable Income (UBTI or UBIT) tax (IRC 514). For 2023, the highest UBTI tax rate is 37%, However, the non-recourse 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 involving non-recourse financing would trigger the UBTI tax if there was greater than $1000 of net income associated with the loan.
6. Open the Account at Any Local Bank
With a Solo 401(k) Plan, the 401(k) bank account can be opened at any local bank or trust company. In fact, IRA Financial can open an account for you at Capital One. However, in the case of a SIMPLE IRA or a Self-Directed IRA, a special IRA custodian is required to hold the IRA funds, such as IRA Financial Trust.
7. 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.
8. 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.
SIMPLE IRA vs. Solo 401(k) Plan
Notwithstanding the above on the Solo 401(k), the SIMPLE IRA does have a number of attractive advantages for small businesses:
- Available to any small business – generally with 100 or fewer employees
- Easily established by adopting a SIMPLE IRA prototype or an individually designed plan document. In fact, you can establish a self-directed SIMPLE IRA quickly and easily with the IRA Financial app.
- SIMPLE IRAs can be self-directed
- No filing requirement for the employer since the IRA custodian would be required to file IRS Form 5498. Whereas, in the case of a solo 401(K) plan, if assets are above $250,000 as of 12/31, IRS Form 5500-EZ must be filed. In addition, one quirky rule with a SIMPLE IRA, is that an employer that adopts a SIMPLE IRA cannot have any other retirement plan at the same time
Moreover, SIMPLE IRA assets cannot be rolled into another IRA or 401(k) plan until the SIMPLE IRA has been opened at least two years.
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 Plan discussed above are why it is so appealing and popular among self-employed business owners. Choosing a Solo 401(k) vs. SIMPLE IRA makes a lot of sense for self-employed individuals, especially for those wishing to gain investment diversification and take advantage of high annual contributions in pretax or Roth or even borrow up to $50,000 tax-free and penalty-free.