Traditional IRA vs. Simple IRA: Which is Better For You?

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Lately, I've been spending more time writing about retirement on the blog for one simple reason: it is so important. Most of us take for granted our access to workplace saving plans like 401(k) and 403(b) plans.

But millions of Americans are entrepreneurs and work for small businesses without access to these plans. Luckily, there are still individual options to prepare for retirement.

Two of these options include Traditional and Simple IRAs.

Today, I'm back to talk about these retirement accounts and help you decide which is best for you.

What is a Traditional IRA?

Traditional IRAs (Individual Retirement Accounts) are a type of retirement account that are available to Americans regardless of whether they have access to a 401(k) or 403(b) plan from their employer. They offer a tax-advantaged way to save for retirement, as contributions are tax deductible on a dollar-for-dollar basis.

However, this deductibility may be limited or eliminated if:

You have access to a workplace retirement plan
You make more than $78,000 if you're single or $129,000 if married filing jointly

Traditional IRA eligibility

Traditional IRAs cast a wide net in terms of eligibility, and they are currently available to a vast array of Americans. There are no age, income, or career-based requirements (at least not to make contributions), and Americans from coast to coast are able to take advantage of these plans.

As I'll cover in a minute, SIMPLE IRAs are only available to a subset of the population.

Traditional IRA contribution limits

In 2023, those with Traditional IRAs can contribute up to $6,500 into their accounts, unless you are fifty years old or older, in which case you can save an additional $1,000 in the form of a "catch-up" contribution.

Typically, these contribution limits are for each calendar year, though you can typically make contributions for the prior calendar year until April 15th (aka Tax Day) of the following year.

Benefits to a Traditional IRA

There are many benefits to saving for retirement in a Traditional IRA account, including:

Tax-deductible contributions, as long as you fall below the income thresholds I mentioned above.

Years of tax-deferred growth: Your contributions and investment gains, dividends, and interest will not be taxed until you withdraw these funds during your retirement. In the meantime, your investments can appreciate more quickly, as taxes will not be deducted.

Many investment options available: In a Traditional IRA, you will find a multitude of potential investment options available to you, including individual stocks, bonds, mutual funds, ETFs, and more. This makes Traditional IRAs an excellent option for those that are looking to tailor their asset allocation and investment strategy to their time horizon and risk tolerance.

Easy to use for estate planning: Another draw of these accounts is their estate planning benefits. Most financial services firms make it is very easy to designate beneficiaries online. And it is crucial to make sure that you do so. When you pass, your account will be passed down to your beneficiaries, who can theoretically take advantage of tax-deferred growth until they decide to make withdrawals.

Where to open a Traditional IRA

There is no shortage of financial services firms that offer IRAs for you to open. But which companies are worth considering, and which just don't stack up?

In 2023, my favorite IRA providers are:

Fidelity Investments
Vanguard
Charles Schwab

1. Fidelity Investments

Fidelity is my top pick and the firm I use to record keep my own IRA. My favorite part about Fidelity is their robust investment research and educational resources. This is not to say that they are not a good pick if you don't plan on picking your own investments (and please don't unless you are sure what you're doing).

Fidelity also offers high-yield core cash positions, meaning that your uninvested cash will earn more interest than you'd earn with your normal checking or savings account. Given the high interest rates and interest rate policy from the Federal Reserve over the past few years, my core position now yields 4.74%!

2. Vanguard

Vanguard is second on my list of the top Traditional IRA record keepers across the country. The second largest financial services firm in the United States by assets under management (AUM), Vanguard offers a wide array of investment options and is known for a good customer service experience.

The main reason that I have not ranked them first is simply because of the technological issues they have experienced over the past few years. And while these issues are usually solved quickly, it is unfortunate to see them happen as frequently as they do.

3. Charles Schwab

You also may opt to consider Charles Schwab. They are a popular brokerage firm known for their customer service and low cost and fee investment options. Similar to both Fidelity and Vanguard, you can choose from a wide array of low-cost index funds, as well as stocks, bonds, and ETFs.

What is a SIMPLE IRA?

A SIMPLE IRA, short for Savings Incentive Matching Plan for Employees Individual Retirement Account, is a retirement savings plan that is offered to self-employed and employees of small businesses that don't have access to more traditional 401(k) or 403(b) savings plans at work.

These plans are intended to make sure that qualifying individuals still have access to advantaged ways of preparing for their future retirement.

SIMPLE IRA eligibility

Contrary to Traditional IRAs, SIMPLEs, as they are colloquially known, are available only to those who either:

Are self-employed
Work for a small business with less than 100 employees and don't have access to a 401(k) or 403(b) plan
Have earned at least $5,000 per year over the past two years

SIMPLE IRA contribution limits

The cool part about SIPLE IRAs is that both employers and employees can make contributions into the account, similar to how a 401(k) contribution match works. In 2023, an employee can contribute up to $15,500 into their SIMPLE, much higher than the $6,500 limit that Traditional IRA carry.

Additionally, plan participants that are aged 50 or older are eligible to contribute an extra $3,500 in catch-up contributions.

In terms of employer matches, they are generally required to match employee salary reduction contributions on a dollar-for-dollar basis up to 3% of each employee's compensation, except in cases of nonelective contributions.

What are elective and nonelective contributions?

Remember - employers have a choice between making either elective or nonelective contributions. But what is the difference anyway?

Elective contributions are contributions made by employees on a salary-deferred basis. Essentially, your contributions will be deducted from your salary on a pre-tax basis and then deposited into your SIMPLE. You can control how much you'd like to contribute to your account, up to the IRA contribution limit of $15,500. If your employer opts for elective contributions, they will make that 3% contribution I referenced a minute ago. While your contributions won't be subject to federal withholding, they will be subject to social security, Medicare, and federal unemployment taxes.

Non-elective contributions, on the other hand, are contributions that are made by your employer. They will make a flat 2% contribution (of your compensation) into your SIMPLE, but they are subject to a $330,000 compensation cap (for the 2023 tax year). This means that the maximum non-elective contribution an employee can receive under current SIMPLE rules is $6,600 this year.

As an employee, you unfortunately do not have control over whether your employer opts for an elective or non-elective SIMPLE.

SIMPLE IRA investment options

Though SIMPLE IRAs may seem similar to a workplace 401(k) or 403(b) plan, there is a noticeable difference as it pertains to available investment options. With a 401(k) plan, employees are limited to those mutual fund investment options selected by their employer, known as a plan lineup.

But with SIMPLEs, employees tend to have much more flexibility as it pertains to their potential investments. It is common for these accounts to have access to:

Stocks
Bonds
Exchange-traded funds (ETFs)
Mutual Funds
Certificates of Deposit (CDs)

Benefits to a SIMPLE IRA

For entrepreneurs and employees of small businesses across the country, there are many benefits to saving money in a SIMPLE IRA. They include:

A way to lower your taxable income in the present: Remember, contributions you make will lower your taxable income. This makes saving money in a SIMPLE a win-win. You'll help yourself pay less in taxes now and help prepare for a fruitful retirement at the same time.

Free money: Much like 401(k) plans, any contributions your employer make on your behalf is free money. Traditional and Roth IRAs do not offer any such capabilities, so naturally, I recommend that you take advantage of any free money offered to you!

Early withdrawal penalty waivers: Generally, SIMPLEs carry the same 10% early withdrawal penalty that most all other type of retirement accounts carry. But there are also waivers to this rule that allow for you to use your funds for qualified educational expenses and first-time home purchases.

Traditional vs. SIMPLE IRAs: which is better?

Deciding whether you want to contribute to a Traditional or SIMPLE IRA doesn't have to be as difficult a decision as it seems to be. To help you make this decision, I recommend that you follow these three tips.

1. Consider how much money you can save

I recommend that you think through how much money you can feasibly save over the course of the year. If you are under age 50 and want to save over $6,500 for retirement this year, you may need to contribute to both your Traditional and SIMPLE IRAs if you opt to use a Traditional, since you will hit the contribution limit. You could conceivably save this much in a SIMPLE, however.

2. Consider early withdrawal penalties

I mentioned a minute ago that a SIMPLE carries a 10% early withdrawal penalty, but this does not tell the complete story. To disincentivize Americans from raiding their retirement accounts, you'll actually be subject to a 25% penalty, plus applicable income taxes.

If you are absolutely sure that you won't need the money in the first two years, however, then this penalty will revert back to the standard 10%.

But if you're on shaky financial footing, this is something that you should keep in mind.

3. Don't pass up free money

If your employer offers you a SIMPLE with a match, it is critically important that you do whatever is necessary to receive it. This won't be an issue with non-elective contributions, though it will be with elective contributions, if your employer offers up to a 3% dollar-for-dollar match.

Conclusion

Regardless of whether you contribute to a Traditional IRA, SIMPLE IRA, or both, the main thing is that you are saving for your retirement. Whether one or the other is better for you depends on your lifestyle and savings habits, but now I want to hear from you.

Which side are you on in the Traditional vs. SIMPLE IRA debate? Tell me in the comments below!

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