For small business owners, SIMPLE IRAs and Solo 401(k)s represent retirement plan options, offering tax benefits.

But when it comes to choosing between a SIMPLE IRA vs. a 401(k), the choice depends on your preferred plan structure (Traditional or Roth), the number of employees at your business, and other factors, such as the ease of termination and contribution limits.

Here’s what you need to know before you choose a plan.

SIMPLE IRAs and Solo 401(k)s at a Glance

Understanding SIMPLE IRAs

Savings Incentive Match Plans, or SIMPLE IRAs, are retirement accounts that offer an easy-to-administer retirement option to small business owners and those who work for them. Under this type of plan, both the employer and employees earning $5,000 or more can contribute to the plan. SIMPLE IRAs are easier to adopt than other common employer-sponsored retirement plans and carry no filing requirements.

SIMPLE IRA tax benefits

Traditionally, SIMPLE IRAs had to be traditional in structure, but the SECURE 2.0 allows for Roth designation as of 2023.  As such, contributions are made with pre-tax dollars and grow in the account tax-free until they are withdrawn during retirement.

Employees benefit from a reduced taxable income each year relative to their annual contribution. Employees can earn tax breaks for up to 50% of start-up costs, up to $500 annually, for the first three years the plan is in effect.

Understanding Solo 401ks

Solo 401(k)s share many of the same characteristics of a standard 401(k) but are exclusively available to business owners. Unlike a SIMPLE IRA, which is available for the employer and their employees, a Solo 401(k) is only available to the employer. Further, the employer must be the only employee — once they hire an employee, except for a spouse — they are no longer eligible to participate in a Solo 401(k).

Solo 401(k) tax benefits

Solo 401(k)s can be Traditional or Roth, and primary tax benefits vary depending on the type of account. Traditional Solo 401(k)s are funded with pre-tax dollars. Funds are taxed upon withdrawal based on the account holder’s income tax bracket at that time. Roth Solo 401(k)s are funded with after-tax dollars, and therefore withdrawals are not taxed.

Solo 401(k)s also allow account holders to contribute as both employee and employer, and contributions made as the employer are tax deductible. Employee contributions aren’t tax deductible, but they do reduce your taxable income.

Contributions and Matching

SIMPLE IRAs

Employers who adopt SIMPLE IRAs for their employees must contribute to their accounts, opting for a matching or non-elective contribution.  Under the matching contribution structure, the business owner can match up to 3% of the employee’s contribution.  With a non-elective contribution structure, the employer must make a 2% contribution for every eligible employee, even if they don’t contribute to their own account.

Employees with a SIMPLE IRA can contribute up to $15,500 from their salary (2023). Employees who are 50 or older can make an additional catch-up contribution of $3,500 if the plan allows. If an employee has another plan in force, the combined contribution limit is $22,500.

Solo 401(k)

Employers who open up a Solo 401(k) can contribute as both the employee and the employer. The annual contribution is $25,000 ($30,000 if you’re 50 or older), and the account owner can elect to contribute up to 100% of their salary up to that limit.  The account holder can also make a non-elective contribution up to 25% of their compensation, though self-employed individuals must also follow contribution limits as indicated in Chapter 5 of IRS Publication 560.

The combined contribution limit of a SOLO 401(k) — employee and employer — is $66,000, not including catch-up contributions, which are available for individuals 50 years of age or older.

Investment Options

Both SIMPLE IRAs and Solo 401(k)s allow for investments in common assets, such as stocks, bonds, and mutual funds. However, both options can be designated as self-direct plans, which expand investment options.

Self-directed SIMPLE IRAs and self-directed Solo 401(k)s can be used to invest in various alternative investments, including real estate, precious metals, tax liens, mortgage notes, private equity, and foreign currency.

Vesting and Employee Participation

SIMPLE IRAs

When a business owner opens a SIMPLE IRA, all eligible employees earning at least $5,000 must also be enrolled in the plan. Employers must contribute to employee plans, either at a dollar-to-dollar matching rate up to 3% of the employee’s compensation or as a non-elective contribution equal to 2% of the employee’s compensation.

Funds held in a SIMPLE IRA, including those from an employer contribution, vest immediately.

Solo 401(k)

Solo 401(k)s are exclusively for business owners who don’t have employees except a spouse. As such, there is no employee participation outside the business owner who also acts as the sole employee. And, since the business owner is contributing to their account, funds in the account vest immediately.

Required Minimum Distributions (RMDs)

SIMPLE IRAs

As of 2023, IRS rules require individuals who have a traditional SIMPLE IRA to start taking RMDs at the age of 73 as long as they turn 72 by December 31, 2022. Individuals who reached 72 before that must begin taking RMDs at 72.

Roth IRAs are not subject to RMD requirements.

Solo 401(k)

In 2023, you must begin taking RMDs from Solo 401(k) at 73 (72 if you reach that age before December 31, 2022). There is no exception for Roth Solo 401(k)s. However, this changes in 2024, at which point RMDs will not be required for Roth Solo 401(k)s.

Plan Termination and Rollovers

SIMPLE IRAs

You can terminate a SIMPLE IRA for the next calendar year by contacting the financial institution that holds the account. You must tell employees that you intend to terminate the plan within 60 days of the new calendar year, which is November 2.  You do not need to alert the IRS.

Solo 401(k)

Terminating a Solo 401(k) is more complex. The IRS requires you to establish a date of termination, which may be done through a plan of amendment or discontinuance of contributions.  In addition, all assets must be distributed within one year of the termination, and “benefits and liabilities under the plan” must be determined, according to the IRS. You must also file a 5500-EZ form with the IRS within seven months of the intended termination date.

As this is a more complex process, it’s best to check the most up-to-date IRS guidelines before terminating.

Takeaways

Both SIMPLE IRAs and Solo 401(k)s can provide adequate opportunities to save for retirement, especially for small business owners.

However, some circumstances can determine which plan may be favorable over another. For instance, a Solo 401(k)s is only an option if you are the sole employee of your business or if you are the only employee except your spouse.

If you have employees or intend to hire employees in a relatively short period, A SIMPLE IRA is a better option. However, it does require the business owner to make either a matching or non-elective contribution for all eligible employees.

If you do not intend to hire employees and want a plan that offers the highest contribution limit, then a Solo 401(k) is likely a better option, as it allows for up to $25,000 in annual employee contributions with additional employer contributions up to $66,000 (not including catch-up contributions for those 50 or older); significantly more than the SIMPLE IRA. It also allows you to contribute as both the employer and the employee.

FAQs

Can I have both a Simple IRA and a Solo 401(k) simultaneously?

If you offer a SIMPLE IRA, you cannot also offer a Solo 401(k). However, if you have a Solo 401(k) and also work for an employer that offers a SIMPLE IRA, you can contribute to both.

Is there a penalty for early withdrawal from a Solo 401(k)?

If you take an early withdrawal from a Traditional Solo 401(k), then you will usually face a 10% penalty. The penalty may be waived under certain circumstances, such as if you’re using it to pay for unreimbursed medical expenses or if you become totally and permanently disabled.

If you take an early withdrawal from a Roth Solo 401(k), you are only taxed if you withdraw from earned interest. You will not be taxed if you withdraw from contributions and the account has been open for at least five years.

Can I convert my Simple IRA to a Solo 401(k) if I become self-employed?

Yes, you can transfer funds from a SIMPLE IRA to a Solo 401(k) if you have participated in the SIMPLE IRA for at least two years. If you have not participated for at least two years, you can only transfer funds to another SIMPLE IRA.

Are employer contributions tax-deductible in both plans?

Yes, if you are the employer, you can deduct contributions to both solo 401(k)s and SIMPLE IRAs, provided the 401(k) is structured as a traditional retirement account and not a Roth.