Often, small legal firms opt for a SIMPLE IRA, only because there are no administrative costs associated with operating this plan. In some cases this can be a big mistake, especially if you have the ability to contribute significantly more to a 401(k) plan. While it is true that SIMPLE has no administrative cost, the biggest cost of using SIMPLE vs. a 401(k) is the income tax on the money that could be contributed to a 401(k) instead. For those in the highest tax brackets, this cost can be as high as 50 percent.
What are the advantages and disadvantages of SIMPLE IRA vs. the 401(k) plan, and how can you make an informed decision on selecting the best type of plan for your practice?
Breaking down the differences
SIMPLE IRA is easy to set up and terminate, and it can be opened at a discount brokerage such as Vanguard so you can have access to high-quality, low-cost investments. No third-party administrator (TPA) is required—operating a SIMPLE IRA is relatively straightforward and can be done by the law firm owner without much assistance. The 401(k) with profit sharing requires the services of a TPA, so there is an added administrative cost and higher complexity compared with SIMPLE. However, a 401(k) with profit sharing allows for a significantly larger contribution.
SIMPLE IRA vs. 401(k) rules of thumb
There is a good rule of thumb that can help you determine which plan might work better for you. A SIMPLE IRA might be a better plan for your law firm if (together with your spouse) you can contribute less than $40,000 a year and/or the cost of 401(k) employer contributions is high (with less than 70 percent of plan contributions going to the owner and spouse). On the other hand, a 401(k) with profit sharing might be a better plan if (together with your spouse) you can contribute close to the plan maximum (approximately $55,000 if both you and your spouse are under 50) and your 401(k) employer contribution is reasonable (with more than 70 percent of plan contributions going to the owner and spouse).
The decision can be straightforward if you fall into either extreme, but what if you are somewhere in the middle? What if you can contribute the maximum, but your employer contribution expenses are relatively high? For those in the highest tax brackets, higher plan expenses might still justify selecting the 401(k) over SIMPLE.
What you’d need to do first is to get a plan design illustration from the TPA that takes into account your firm’s demographics to see what your potential plan contributions and expenses would be. Once you have an illustration, your retirement plan adviser should do a 401(k) vs. SIMPLE side-by-side analysis that takes into account your specific situation so that you can select the right plan for your firm.
SIMPLE vs. 401(k) example
The biggest downside of SIMPLE is that it has a lower contribution limit than the 401(k) plan. When you are just starting your own law firm and have a significant amount of student and firm debt, SIMPLE might be a perfect plan for you. However, when your debt is mostly paid out and your firm profits grow, so does your highest marginal tax bracket.
For many attorneys, some of their income might fall into the highest federal and state tax brackets, 39.6 percent for federal and as high as 13 percent for state (if you are in CA). Thus the cost of keeping your money after-tax might be as high as 50 percent, so the key to successful tax planning will be to shelter as much of your highest tax-bracket income as possible, which can be accomplished with an appropriately designed 401(k) plan.
Some attorneys might even want to go an extra step and set up a Cash Balance plan together with the 401(k), to shelter even more of their income from taxes. Whether your spouse is working elsewhere or not, you can (and should) hire your spouse, provided that the numbers make sense—this can potentially give you tax and income benefits.
While the 401(k) employer contribution for a small large firm can be lower, it can also be higher for a larger practice with more employees and partners. However, if the law firm has several partners, employer contribution expenses will be shared among the partners, so per-owner expense for a large law firm can be lower than for a smaller one. Many smaller law firms with only two to four employees can have significantly lower employer contributions and when employees are significantly older than the owners, the profit sharing plan might not be a viable option.
If employees do not participate in a SIMPLE IRA, the owner does not have to match their contribution, and if they do, the owner will have to pay them a 3 percent match. Similarly, there is a 401(k) plan design that uses only matching—rather than profit sharing—that works the same way: employees get a match only if they participate, and get nothing if they don’t.
Even though the cost of having a 401(k) plan for this practice is higher than the cost of a SIMPLE, a 401(k) plan can provide the owner the means to save significantly more money for retirement while lowering his or her tax liability.
SIMPLE IRA can be a great startup plan, but eventually your law firm will need a 401(k) plan, as those in the highest tax brackets can benefit significantly from making higher 401(k) contributions, which translate into larger retirement savings. There are a number of other reasons why a 401(k) plan might work better for some practices.
A 401(k) plan design can be customized, which can afford advantages over the SIMPLE’s standard design. For example, you can exclude some highly compensated employees from a 401(k), but you can’t do that with SIMPLE. If you hire a highly paid associate, he or she will have to participate in a SIMPLE, but he or she can be excluded from participating in a 401(k) plan. A SIMPLE IRA has a single hard-coded design, while your 401(k) plan can be custom-designed to minimize your employer contribution while maximizing your own.
The 401(k) will also give you the ability to make backdoor Roth contributions, Roth salary deferrals, or in-plan Roth conversions, and accept incoming rollovers—none of which are allowed with the SIMPLE IRA plan. If you are 50 or older, a 401(k) also allows a $6,000 catch-up contribution, while a SIMPLE’s catch-up is only $3,000. If you are not an expert at investment management, a 401(k) can be a great platform through which you can get personalized investment management advice and services from an ERISA (Employee Retirement Income Security Act) 3(38) fiduciary adviser.
Both SIMPLE IRA and 401(k) have a number of advantages and disadvantages, and without a complete analysis it can be difficult to decide which one would be better for a specific law firm (unless you happen to fit neatly into the examples discussed above). To make the right decision, you will need to do an accurate cost vs. benefit analysis, which includes a 401(k) plan design study and side-by-side comparison of the best 401(k) plan design with a SIMPLE IRA for your specific situation.