SIMPLE IRA vs. traditional IRA: What's the difference?

Two popular options for saving for retirement are Savings Incentive Match Plan for Employees (SIMPLE) IRAs and traditional IRAs. Each has advantages and disadvantages. Choosing whether you want to save for retirement with a SIMPLE IRA vs. traditional IRA is a matter of identifying which best suits your needs.

To understand which is best for helping you reach your retirement goals—and if you want to consider using both—here are details about the key differences, including eligibility, annual contribution limits and tax penalties for early withdrawals.

SIMPLE IRAs are a type of retirement account that provide a convenient way for both employees and employers to contribute to an employee's retirement savings. They are established by small business employers and allow both the employer and employees to make contributions.

SIMPLE IRAs are a great way to experience the effect of compound interest, and they have built-in tax advantages.

Traditional IRAs are stand-alone retirement accounts that aren't connected with employers. You open one through a financial institution and make contributions that benefit from compound interest and tax-deferred growth over time.

Even if you have access to an employer-sponsored retirement plan like a SIMPLE IRA, you still can contribute to a traditional IRA and boost your savings.

The main distinctions to know about SIMPLE and traditional IRAs are who qualifies to open and use each account, who can contribute to it, the annual contribution limits and a small difference in the penalties for early withdrawal.

SIMPLE IRAs have specific eligibility requirements while traditional IRAs are more flexible. It's important to note, though, that if you have a SIMPLE IRA, you also can have a traditional IRA and vice versa. You don't have to choose just one if you're eligible for both.

Only employers who have fewer than 100 employees who make $5,000 or more per year can offer SIMPLE IRAs if they don't offer any other retirement plan. People who work for themselves, such as contractors, freelancers, consultants and shop owners, can fall into this category.

If you are an employer considering establishing a SIMPLE IRA plan, you must allow all employees who qualify to participate in the plan.

If your employer offers a SIMPLE IRA, you're allowed to participate as long as you earned at least $5,000 in any two calendar years and expect to earn at least $5,000 in the current year as well (though your employer may choose to make these requirements less restrictive). 

To qualify for a traditional IRA, you or your spouse must have earned income from wages, salaries or tips from working. Income from real estate rentals, interest, dividends and other types of passive income doesn't count.

There are no age requirements or income thresholds to open a traditional IRA.

Far more contributions can be put into a SIMPLE IRA annually than a traditional IRA, so a SIMPLE IRA may help you build your retirement savings more robustly.

SIMPLE IRAs are an employment-based retirement savings tool, and both the employer and employee can contribute.

If you're a business owner who offers a SIMPLE IRA plan, your company will have certain funding requirements. It won't be only the employees putting money in. You must either:

• Contribute a mandatory 2% of an employee's salary to their account (to a salary maximum of $345,000 for 2024), regardless of whether or how much the employee contributes.
• Elect to make a 100% matching contribution of up to 3% of the employee's salary.

In addition, employers may contribute an additional amount that is the lesser of 10% of each employee's compensation or $5,000. If made, this contribution must be applied uniformly.

In 2024 you can contribute up to $16,000 per year if you're younger than 50 or up to $19,500 per year if you're 50 or older. Contributing is as simple as setting up automatic contributions from payroll.

Your employer will be required to make mandatory contributions to your SIMPLE IRA. See employer details above. You are immediately vested and will keep all employer contributions regardless of how long you participate in the plan.

Traditional IRAs have an annual contribution limit in 2024 of $7,000, or if you're 50 or older, a catch-up provision allows you to contribute up to $8,000. This limit, though, applies to all the traditional and Roth IRAs you hold in total. On its own, that's often not enough to meet retirement goals.

Both SIMPLE and traditional IRAs allow you to defer paying income taxes on the money and its earnings until you make withdrawals. Both accounts are designed with this tax advantage to encourage retirement savings that compound over time.

SIMPLE IRA tax-advantages for employers

Contributions are tax-deductible for the employer, within legal limits.

SIMPLE IRA tax-advantages for employees

Since SIMPLE IRAs are funded with pre-tax dollars, your contributions will lower your taxable income for that year. Then, your investments will grow on a tax-deferred basis. This means that you won't owe any taxes until you start taking withdrawals.

Traditional IRA tax-advantages

Traditional IRAs also allow contributions to grow-tax deferred until you make withdrawals. You also may be able to deduct your contributions in the year they are made:

• If you make below the MAGIs (modified adjusted gross income) listed, you can make a full tax deduction of your contributions.
• If you make between the maximum MAGI listed, you can make a partial deduction of your contributions.
• Although you still can contribute to an IRA, you will not be eligible for the tax deduction if your MAGI exceeds the top of the MAGI thresholds.

Your investment choices between a SIMPLE IRA and traditional IRA generally will be the same. Each allows you to invest in most securities, including stocks, bonds, certificates of deposit (CDs), mutual funds and exchange-traded funds (ETFs).

Since they are meant for retirement, both a SIMPLE and traditional IRA have a penalty for taking money out before reaching age 59½ unless you qualify for an exception such as a birth, an adoption, educational expenses or a first-time home purchase. You can view the full list of exceptions here.

• For both a SIMPLE IRA and traditional IRA, it's a 10% penalty on top of taxes owed for early withdrawals.
• For SIMPLE IRAs only, that penalty increases to 25% if taken within the first two years of participating.

You also are subject to required minimum distributions (RMDs) with each account type. Between ages 73-75, depending in your birth year, you must begin withdrawing at least the RMD even if you are still working.

SIMPLE IRAs and traditional IRAs are both excellent savings vehicles for building a nest egg you can withdraw from in retirement. A SIMPLE IRA may be better if you have access to one, but you can set up a traditional IRA on your own. You also may be able to so both—contribute to a SIMPLE IRA and a traditional IRA. Or you can explore other options, including Roth IRAs and SEP IRAs.

To gain clarity on your options and get help understanding which account may be best for you, contact a local Thrivent financial advisor to discuss your personal situation.