The Death of the SIMPLE IRA

You may not be aware, but one of America’s retirement plans has died. Okay, not died (does a statute ever really die?) but it is on life support, a vegetable, or otherwise is essentially on its way out; if not quickly, quietly. The SIMPLE IRA is a form of small business retirement plan you may or may not be familiar with, but we colloquially over the years have referred to it as “baby’s first retirement plan” for a small business. It has occupied a role as a pre-401(k) plan for a business with a few employees. It’s never the first choice for a solopreneur or a partnership, for which the individual 401(k) and SEP IRA have served as better choices respectively. Yet it has satisfied a niche in which a full 401(k) plan, whether due to compliance costs or matching costs, has been found to be “too much.”

However, as the marketplace for 401(k) plans and retirement plan services has become more robust, and as legislators in more states like Colorado have passed requirements that businesses offer retirement plans of some variety or otherwise enroll their employees in a public option, the role of the SIMPLE IRA has come further into question, even as it has slipped further into obscurity. So today, we’re talking about the nature of a SIMPLE IRA plan, the precursors of its demise as a retirement plan, and where small businesses go from here.

Getting to a SIMPLE IRA

Let me explain the basic sequence of questions that guides a financial planning professional to recommend a SIMPLE IRA to a small business owner. There are some more nuances to the flow here, but it’s relatively straightforward.

1. Are you entirely self employed or do you have employees?
   1. If self-employed without employees, recommend Individual 401(k).
   2. If self-employed with employees, ask question 2.
2. If you have employees, are they actually W2 employees, or are they 1099 contractors?
   1. If they are 1099 contractors, recommend Individual 401(k).
   2. If they are W2 employees, ask question 3.
3. Are you looking to maximize your personal benefit from having this retirement plan or are you looking to provide a decent benefit for your employees?
   5. If looking to provide a decent benefit for employees, skip to question 5.
   6. If looking to maximize personal benefit, ask question 4.
4. How many employees do you have and how long has the longest-employed employee been with you, and what is the average tenure of an employee at your company?
   1. If the longest-tenured and average answers are less than 3 years, recommend a SEP IRA.
   2. If the longest-tenured or average answer is greater than 3 years, move to question 5.
5. Do you want to keep your compliance and matching costs as low as possible, or do you want to provide a robust conventional retirement plan?
   1. If robust and conventional, recommend a 401(k) plan.
   2. If keeping costs as low as possible, recommend a SIMPLE IRA.

In following the flow, the objective of a financial planner is to help the business owner optimize their personal financial outcomes from offering a retirement plan, and when that’s no longer possible due to the employee composition, whether they want to minimize their costs or whether they want to pull up their big kid pants and offer a conventional company retirement plan, aka, a 401(k) plan. For a brand new startup business, minimizing costs can often be the natural choice. As we’ll discuss in a moment, that natural choice has traditionally been the SIMPLE IRA, but as we’ll discuss just past that, we’ll come to find that it’s really not the right answer anymore.

What has made the SIMPLE IRA the “natural choice”?

Traditionally a few things have made the SIMPLE IRA a natural choice for a business owner looking to keep their costs low for the retirement plan.

First, SIMPLE IRAs are so templated as a plan structure that they do not have any sort of compliance testing required to ensure that the plan does not unduly benefit owners and managers as compared to employees. Everyone ends up with the same contribution limits and the same matching options made available to them, so that removes the concern that there could be any “discrimination” on the part of the plan.

Second, SIMPLE IRAs have a less generous  matching or automatic contribution formula (which is actually called a non-elective contribution.) Specifically, the plan either requires the employer match up to 3% of the wages an employee owns and contributes to the plan, or that the employer automatically contribute 2% of the wages an employee earns but without requiring that the employee also contribute to the plan. This is by default, less expensive than a 401(k) plan, which will typically require that the owners match 4% or contribute 3% automatically without employees also contributing (more on this later).

Third, because SIMPLE IRAs have no formal compliance testing and the matching formulas are so low, there are typically no explicit administration costs. That is to say, no third-party vendor is sending the business owner a bill for having the plan in existence, which also keeps the costs lower.

The confluence of these three factors have made the SIMPLE IRA very popular for small businesses over the years, and even a few small businesses cling onto this plan structure until they reach the statutory limit of 100 employees. But, as we’re about to discuss, those factors are diminishing in their appeal.

How a 401(K) Compares

All of the things that make a SIMPLE IRA appealing are factors that can make a 401(k) plan unappealing. There is no templated plan structure other than the 401(k) safe harbor structure, which lets the plan pass compliance testing automatically but requires higher matching or non-elective automatic contributions. The plans are also complex enough that even a safe harbor plan will require an administration company to perform compliance testing and complete annual reporting information for the Department of Labor and IRS in the form of the 5500 filing.

However, the marginal increase of these costs compared to the savings of the SIMPLE IRA is a margin that has steadily declined over the years. To give you some idea, ten years ago it would typically cost $2,500-$5,000 per year in administration costs to have a platform and administration performed for even a small 401(k) plan. Further, the matching costs on contributions meant that the business would need to pay anywhere from 33%-50% more in matching or non-elective contribution costs than the minimal formulas prescribed by the SIMPLE IRA (bear in mind, those percentages are relative, not literal amounts of wages). But, over the past several years, companies such as Guideline have steadily brought the price of the platform and administrative compliance down to the point of as little as a few hundred dollars annually. Further, there have been tax credits for several years now that defray or even make it a net profit to establish a 401(k) plan.

For example, a plan on the Guideline platform with ten employees looks to have a monthly platform and compliance spend of $169 per month or $2,028 annually. Yet, there is a startup credit that will pay off an equal amount of the tax liability to the platform costs is available for the first three years, and there is even an opportunity to carry unused tax credits forward to subsequent years to subsidize the plan well into half-a-decade of its existence, by which time the company should have presumably grown revenue adequate to offset the nominal cost.

Consider also the potential increase in costs of the matching formulas, e.g. 4% versus 3% and 3% versus 2%. Take an example of a $1 million dollar service business, for which a benchmark rate of spend on employee compensation would be 50% or $500,000. A 3% matching formula under the SIMPLE IRA would suggest as much as $15,000 in matching costs might be incurred by the business, while a 4% matching formula would increase that cost to $20,000 per year, or $5,000 more. Yet, $5,000 would represent 0.5% of the revenue of that company, and in return, the company now has a higher quality retirement plan that permits both the owners and managers to contribute more to the plan, but is also more recognizable as a benefit to potential employees.

Set the Hard Dollar Costs Aside

Consider what is perhaps the Achilles heel of the SIMPLE IRA relative to the 401(k): There’s no money in it. That is to say, in the financial sector, SIMPLE IRAs are so frequently an under-utilized benefit with such low contribution and accumulation that there is no real competition to serve the SIMPLE IRA market.*

This then means that in a literal logistics sense that SIMPLE IRAs are actually “hosted” as individual accounts at a custodian like Charles Schwab or Vanguard, and the process of funding them involves a literal physical letter breaking down the contribution directions and a literal physical check. Compare this to the 401(k) plan, which likely integrates directly with the payroll software and automates both the payroll functions and transaction elements. That doesn’t seem like a big deal, until you think about the time, energy, and even payroll costs of remitting 24-26 checks and a manually filled out form each year. Add up 30 minutes of time for each occurrence, pay people twice per month, and even at minimum wage this process is costing a business at least $191 throughout the year, god forbid there’s ever a hiccup or a mistake made in that manual process.

Take out the payroll costs, even, and ask yourself the question: Does my small business attract top talent by offering a recognizable 401(k) plan or an obscure SIMPLE IRA? Does it retain top talent by saving 1% on matching costs or does it waste money on turnover and recruitment costs? Is this the robust culture of compensation I want to offer to my team to reward them for the hard work they provide my small business?

The Funeral of the SIMPLE IRA

You could very easily argue that we’re putting the cart before the horse, or to abuse the analogy, burying something that’s still alive. SIMPLE IRAs exist today, and will continue to exist for many years to come, languishing as they are unless someone dives into the blue ocean. However, there is a world in which any small business owner must come to ask themselves whether they are a premiere employer offering state of the art benefits, or whether they’re clinging onto a vintage option for fear that they cannot outgrow the costs it poses, but seen and unseen.

*For anyone in the Fintech and investment custody world, I’m sure there’s a business opportunity here, so go solve that problem!