Attention Business Owners: Dump Your 401(k) Plan For This

Written By
Paul Tracy
Updated January 16, 2021

The 401(k) provides amazing benefits to both employers and employees, who both pick up big tax savings on contributions. The 401(k) also boosts employee loyalty and satisfaction, and creates a path for millions of American workers to save for retirement.

Those benefits have driven participation and contribution rates in the past 12 years, with total domestic 401(k) assets more than doubling to $3.6 trillion at the end of 2012 from $1.7 trillion in 2000.

But even though the 401(k) is a great investment for both employers and employees, it doesn’t come without drawbacks -- and one of the biggest is cost. Not only are 401(k) plans expensive for companies to administer, they are expensive for participants.

According to a report from Demos, a public policy organization, "an ordinary median-income, two-earner household will pay nearly $155,000 over the course of their lifetime in 401(k) fees that will consume nearly one-third of their investment returns."

This flies in the face of investors who think 401(k) participation is free. Whereas the median expense ratio for plans with more than 10,000 participants is 0.43%, the expense ratio for plans with fewer than 100 participants is 1.29%, a sharp premium. Having fewer employees to absorb fixed expenses makes 401(k) participation more expensive for both employees and employers, and that creates barriers for small companies that want to provide tax-deferred benefits to their employees.

That is why one low-cost alternative to the 401(k) is gaining in popularity.

The SIMPLE IRA (Savings Incentive Match Plan for Employees Individual Retirement Account) is an employee-sponsored plan that enables employees to invest in a tax-deferred account to save for retirement. The SIMPLE IRA offers simpler and less costly administration rules, but it's exempt from federal regulations that protect Americans' retirement assets.

The SIMPLE IRA is available to small businesses with fewer than 100 employees and can be funded with pretax salary income, but those contributions are still subject to Social Security, Medicare and federal unemployment taxes.

There are a number of reasons why the SIMPLE IRA is an excellent alternative to the 401(k) for small businesses looking for value.

Easy To Set Up

The SIMPLE IRA is easy to set up and administer. The brokerage firm provides all the documents and materials needed for sponsors and participants to enroll. Applications can be completed within days. And with a universe of brokerage firms offering competing plans, plan sponsors have the opportunity to choose from different levels of support and service.

Less Expensive

Setting up a 401(k) plan usually requires a big down payment and then high annual maintenance fees -- not to mention the fees paid by the plan's participants -- which can be cost prohibitive for a small business. In contrast, the SIMPLE IRA is low cost, with no fees. Maintenance costs are low, too: For instance, Vanguard charges SIMPLE IRA participants with accounts of less than $10,000 an annual fee of $10, which is waived for accounts of more than $10,000. Those savings can add up to thousands of dollars a year for participants against the high expense ratios of the small-business 401(k).

More Investment Options

The SIMPLE IRA offers more variety. Most 401(k) plans offer a fairly limited selection of equity and fixed-income mutual funds. Not only does that severely limit access to a broader array of securities and markets, mutual funds are also expensive compared with low-cost index funds, adding another weight to its draining fee structure. But with a SIMPLE IRA, plan participants have access to individual stocks, currencies, commodities, exchange-traded funds and international markets.

Comparable Contribution Limits

Here, the 401(k) comes in ahead of the SIMPLE IRA. The annual contribution limit this year for a 401(k) is $17,500, compared with a $12,000 limit for the SIMPLE IRA and the $5,000 limit of a regular IRA. For participants over the age of 50, the contribution limits for both jump, to $23,000 for the 401(k) and $14,500 for the SIMPLE IRA.

Similar Withdrawal Schedules

The withdrawal schedules for the 401(k) and SIMPLE IRA are similar: Participants become eligible for qualified withdrawals at the age of 59.5. But the two plans handle early withdrawals differently. The 401(k) carries a 10% penalty for an early withdrawal, while the SIMPLE IRA can carry up to a 25% penalty for ineligible withdrawals in the first two years before falling to 10%. Both plans require minimum distributions at the age of 70.5.

Employer-Friendly Tax Requirements

Employers offering 401(k) plans and SIMPLE IRAs gain tax benefits from both by making employee contributions. But the reporting requirements for the SIMPLE IRA are more flexible -- 500 Series form reporting is not required. Companies running a SIMPLE IRA simply take a deduction on their business tax returns for employee contributions, reducing reporting and administrative work for plan sponsors. Participants in both the 401(k) and SIMPLE IRA are allowed to deduct contributions from taxable income.

The Investing Answer: Getting started with a SIMPLE IRA is easy and quick. Accounts for both sponsors and participants are free to open, and most brokerage firms offer onboarding support and service. The brokerage firms may offer investment support as a premium service, but if not, it’s a great idea to consult with an investment advisor to help guide the investment process.

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