Planning with SIMPLE IRA Retirement Plans
  
Overview

A Savings Incentive Match Plan for Employees or SIMPLE is a written salary reduction arrangement, somewhat like a 401k, under which eligible employees may elect pretax deferred contributions of up to $6,000 per year. The employer may add to that with a 3% of compensation match on up to $200,000 of compensation and that’s all the employer needs to contribute, but contributions must be made even if the business is losing money. Alternatively, the employer may make a nonelective 2% contribution. There is no testing for discrimination. There is no administration required. There are no annual reports to IRS. The setup is so simple that almost any employer can do it. There is no percentage of compensation limit on the $6,000 pretax salary reduction...it is a flat sum regardless of the compensation amount(except compensation must be at least $6,000). Funds, which are held in the individual employee’s accounts, are completely vested, allowing participants complete control over investments and portability(they can "walk" anytime). Employees who withdraw funds within two years are penalized 25%, instead of the 10% premature distribution penalty. Accounts are not protected by federal law against "alienation"(the IRS or creditor’s attachments). There are no minimum participation rules, top-heavy plan rules, minimum coverage rules, or 401k annual tests. The employer cannot maintain a qualified plan or SEP plan concurrently with a SIMPLE nor can the employer make a contribution to a SIMPLE for any year in which a qualified plan or SEP plan is maintained.

Establishing a SIMPLE

A SIMPLE plan may be established using either IRA accounts or as part of a 401k plan, which means borrowing, no alienation, and hardship withdrawals, features that cannot be offered with an IRA SIMPLE.

Who Can Set Up a SIMPLE

Any employer(proprietorship, corporation, partnership, etc.) that has fewer than 100 employees who earned $5,000 or more during the preceding calendar year is eligible. Employees covered by a collective-bargaining agreement, nonresident aliens, leased employees, self-employed contractors, and employees who have not met the plan’s minimum participation requirements must be included. Also, employees of related companies must be counted both for the 100 employee rule and for participation.

An employer can establish a SIMPLE IRA on any date between January 1 and October 1. If an employer previously maintained a SIMPLE IRA, a new SIMPLE can only be established on January 1. If an employer started business after October 1, a plan can be established before December 31.

An employer can establish a plan by adopting either an IRS model or a prototype plan. The IRS model must be adopted without modification whereas if the employer has nonresident aliens, an approved prototype plan from a bank, S&L, mutual fund company, insurance company, or other approved financial institution must be used. The developer of a prototype plan must seek an opinion letter from IRS.
 
Designated Financial Institutions

Contributions of SIMPLE IRA? funds may be made to separate SIMPLE IRA accounts for each employee or to one designed financial institution. If the employer has lets say 10 employees each of whom wants to allocate funds to at least three different investments, using one designated financial institution makes a lot of sense(and saves a lot of check writing), especially if the financial institution allows transfers to other SIMPLE IRA accounts.

Forms to Adopt A SIMPLE IRA

An employer may file either Form 5304-SIMPLE, which is the IRS model agreement, or the 5305-SIMPLE, which is the designated financial institution form. Pages 1, 2 and the top half of page 3 must be completed and signed by someone having authority to do so. Neither of these forms can be used if the employer wants to cover nonresident aliens with US source earned income. Instead, the employer must use a financial institution’s prototype plan.

An employer must give employees notice that they can defer up to $6,000 of their compensation. The employer may do that by furnishing employees with a copy of page 3 of Form 5304-SIMPLE or 5305-SIMPLE, as well as copies of pages one and two. Deferrals can start after the later of 1) the date the employee becomes eligible or 2) the date the employee executes the deferral agreement.
 
Participation Requirements

The following employees, etc. must be given the opportunity to participate:

any and all employees who earned at least $5,000 (from the employer) during any two prior years and who reasonably expect to receive $5,000 in the current year, regardless of age, gender, job classification....i.e. no discrimination,

any and all leased employees and self-employed independent contractors, and

all employees must be given the opportunity to execute deferral agreements.

Employees covered by a collective-bargaining agreement and nonresident alients who received no US source earned income may be excluded. The employer may provide more liberal requirements, such as lower compensation thresholds, but not more restrictive. All employees of related companies, as defined under the aggregation rules of IRC Section 414(b), (c), and (m) must be allowed to participate. Regardless of whether the employee is age 8 or 80, they can participate.

Note that these requirements differ from SEP plans where any employee who earned $400 or more in a calendar year must be in the SEP plan.
 
Contributions

There are three types(and only three) of contributions that can or must be made:

employee elective deferrals of up to $6,000 or 100% of compensation whichever is less,

employer manditory matching contributions of the employee’s deferral to a maximum of 3% of compensation of up to $200,000 with an option of electing to change the matching percentage to as low as 1% but for only two out of five years (the maximum contribution is $6,000), or

employer nonelective contribution of 2% of employee compensation of up to$160,000 for each eligible employee, regardless of which employees makedeferral elections. The maximum contribution is $3,200.

A key point: the employer 3% matching contributions are manditory. The "substantial and recurring" standard(at least one in every three years) for profit sharing plan contributions does not apply, so cash flow of the business must be such as to be able to meet this obligation. The employer cannot use a match of less than 3% for more than two years out of a five year period. For an employer whose every employee is participating, the 2% nonelective contribution is less expensive and simpler.

An employer may(but is not required to) contribute matching or nonelective contributions for employees who earn less than $5,000. An employer making the nonelective contributions must notify employees at least 61 days before the beginning of the calendar year of the election.

The maximum amount an employee can "put away" in a SIMPLE IRA is $12,000. However, practically it is only $10,800 because if the owner of the business is the one trying to reach the maximum $12,000 and to do so, that owner-participant has to pay Medicare tax on the incremental compensation amount over $160,000 of 2.9% of $40,000 or $1,160 in order to obtain a deferral of $1,200 (3% of the difference between $200,000 and $160,000), it doesn’t make sense to contribute over the $160,000 maximum.

An employee may stop participation i.e. making elective deferrals at any time during the year, but the plan may prohibit the employee from re-entering the plan until the beginning of the next calendar year.
 
Vesting

All contributions to a SIMPLE IRA are fully 100% vested from the moment made. In other words, the employee can terminate employment the day after an employer contribution is made and that employer contribution belongs entirely to that terminating employee. A SIMPLE IRA is not the best plan suited to retain employees.

The Elective Deferral Limit

The SIMPLE IRA deferral limit of $6,000 is integrated with the maximum 401k deferral limit of $10,000. Therefore, if an employee participates in a qualified plan 401k with another employer and makes elective deferrals in that plan, the SIMPLE IRA deferral limit equals the $10,000 minus the deferrals to the 401k plan.

For example, if Joe Black works for ABC Company and defers 6% of his $100,000 salary and also receives a director’s fee from XYZ Company of $5,000, he can only defer $4,000 of that fee in a SIMPLE IRA($10,000 minus $100,000 x 6%).
 
When Are Employer Contributions to be Made and Deducted

SIMPLE IRAs are a calendar year plan, they cannot use a fiscal or plan year. Therefore, contributions are based on W2 compensation or self-employment income for a calendar year. Normally, SIMPLE IRA contributions are deducted for the year in which the compensation or income is earned. They must be made on or before the due date, including extensions, for filing the individual or corporate tax return. This compares with regular and Roth IRAs where the contributions have to be made by April 15.

If a corporation is on a fiscal year, say June 30 1998, the contributions must be made by September 15, the normal due date based on the 2 1/2 month rule or six months after that(March 15) if an extension is filed. However, the contributions are based on 1997’s plan year and 1997 W2s.
 
Time for Depositing Employee Deferral Contributions

Employee elective deferrals must be deposited either with the designated financial institution or in the individual employee IRA accounts no later than 30 days after the month the deferrals were withheld. Note that the employer match or nonelective contribution may be made by the due date of filing of the return. The definition of employee includes the self-employed business owner, independent contractors, and leased employees.

Payroll Taxes

While employee elective deferrals are excluded from federal gross income (and most states), they are taxable for FICA, FUTA, and most states unemployment taxes. Employer matching or nonelective contributions are not subject to payroll taxes.

Active Participant Status

Participants in a SIMPLE IRA are considered to be active participants in an employer-provided pension plan. Therefore, the employer must check the "pension plan" box on the W2 and the employee will be subject to the AGI limits for individual IRA contributions. This rule applies even when the employee has not elected deferrals and the employer has chosen to make the nonelective contributions.

Investment/Fiduciary Responsibilities

Employees are treated as exercising full control and fiduciary responsibility over their accounts the earlier of the day they make an affirmative election on how to invest the contributions or one year after the account is established. The employer should not be liable in any litigation over an employee’s bad investment decisions.

Nondiscriminatory Testing

There is no nondiscrimination testing for a SIMPLE IRA, such as what occurs in the typical 401k profitsharing plan. As long as an employer stays within the contribution limits(no deferrals above $6,000, no matching contributions above 3%, no nonelective contributions above 2%, and no other contributions by either employer or employees), the plan is considered to have met the nondiscrimination tests.

Distributions

Since SIMPLE IRA contributions are made to IRA accounts, it follows that some of rules for traditional IRAs would apply and generally they do for distributions.

The following rules apply:

distributions are taxed as ordinary income at the marginal tax bracket; they are not eligible for the special lump-sum five-year averaging,

distributions prior to age 59 1/2 that are not "qualified" are subject to the premature withdrawal 10% penalty,

distributions made within a two-year period starting from the date on the employee first participated are subject to a 25% premature withdrawal penalty, instead of the 10% penalty,

loans are not permitted,

If an employee terminates employment(or a self-employeed goes out of business) and the two-year period has expired, the SIMPLE IRA account is treated as a traditional IRA. A rollover is not necessary. If the employee desires to rollover the IRA, he may do so without fear of any penalty.
 
Distributions Not Subject to the Premature 10% Penalty Tax

The 10% premature penalty tax does not apply to the following distributions from IRAs:

distributions made on account of death or disability,

distributions that are part of a series of substantially equal payments for the life of the employee or joint lives of the employee and a designated beneficiary. For distributions from qualified plans other than IRAs this exception applies only after separation from employment,

distributions to pay IRC Section 213 medical expenses over the 7.5% AGI limit,

distributions made as a result of an IRS levy,

distributions used to pay medical insurance if the individual has received unemployment insurance for at least 12 weeks,

distributions up to $10,000 used to buy a principal residence for a first-time homebuyer, and

distributions used to pay for qualified higher education expenses.

The last one may provide a way for a parent who owns a business to invest, shelter, and reduce income taxes on education funds by employing a child in the business and allowing the child to participate up to the maximum $6,000 deferral in a SIMPLE IRA.
 
Rollovers

An employee may rollover a SIMPLE IRA account taxfree to a traditional IRA account, but only after the initial two-year period from date of first participation has expired. Rollovers prior to that may only be made taxfree to another SIMPLE IRA. Otherwise, the rollover will be subject to the 25% premature withdrawal penalty and will also be subject to income tax. Furthermore, the rollover may trigger the 6% excess contribution penalty imposed if the $2,000 traditional IRA contribution limit is exceeded.

Distributions can never be rolled over into a qualified plan, a ROTH IRA, a SEP, or an education IRA.

As with any rollover, a direct trustee to trustee rollover will prevent the trustee from having to withhold income tax. Also, a rollover which is made first to the employee/taxpayer must be rolled over within 60 days after the participant receives it, or more conservatively within 60 days of the date on the check.

If an employee terminates employment within the two year period, the employee may roll the SIMPLE IRA account to another SIMPLE IRA account with the new employer or leave the account alone until the two year period expires. Then it can be rolled over to any traditional IRA account. During the period between termination of employment and the expiration of the two year period, no contributions may be made to the SIMPLE IRA account.
 
SIMPLE 401Ks

Simple 401k plans are very much like SIMPLE IRA plans with certain exceptions which are as follows:

participation requirements are that the employee must be at least 21 years of age and have one year of service for deferrals and up to two years for the matching contribution,

there is no option to have the matching contribution 3% be less than 3%,

employee deferrals are limited to the lesser of 25% or $6,000,

the SIMPLE 401k plan must meet the minimum coverage rules which are either one of two tests

the plan must cover nonhighly compensated employees i.e. 70% of the number of highly compensated employees, or

70% of the average benefits of highly compensated employees must be for nonhighly compensated employees,

deferrals together with employer matches cannot exceed 25% of employee compensation,

loans are permitted to employees, other than owner-employees, if the plan allows them,

in-service withdrawals for hardship are allowed (but 10% penalty applies),

federal alienation and anti-garnishment provisions apply, and

the employer must file the Form 5500 Annual Report (read: extra cost).

The main advantage of the SIMPLE 401k is that it avoids the nondiscrimination testing on deferrals and matching contributions which tests tend to disqualify regular 401k plans.
 
Anti-Alienation

A SIMPLE plan has no protection against creditors of all kinds. In any bankruptcy situation, the employees SIMPLE account is exposed to creditors.

Reporting Requirements

Although there is no administration or lengthy Form 5500 to prepare and file, there is a Form 5498 for SIMPLE IRAs that must be filed by April 30 by the trustee of the plan. If the plan has a designated financial institution, that company would be named as trustee and would be responsible for preparing the form and filing. If the employer adopted the IRS model agreement, then the employer more than likely will name himself as trustee, and be responsible for the preparation and filing. The form is simple to prepare; it asks for contributions, deferrals, rollovers, and the fair market value of the account(s). Failure to file the form results in a $50 per day penalty. The penalty can be abated for reasonable cause.

The trustee must also furnish the employer with an account statement showing the end-of-year balance and the twelve-month activity.

Finally, the trustee must furnish the employer(who in turn furnishes the employees) with a summary plan description which contains such basic information as the employer’s name and address, requirements for participation, benefits, time and method of making elections, the effects of withdrawals, procedures for withdrawals, and name and address of the trustee.
 
Employer Notices

The employer is responsible for notifying employees that they have a 60 day period each year to make new deferral elections or modify old deferral elections. Generally, this period runs from November 1 through December 31. For new plans or employees, the period begins on the first day the employee becomes eligible to participate in the plan. This can vary depending on what the employer selected for eligibility requirements when the plan was set up. The form of notice is usually either a letter or a posted notice.

When Are SIMPLE Plans Suitable

SIMPLE plans are suitable anytime an employer wants to simply the paperwork and save on costs of administration of qualified plans. They are suitable when the employer wants or needs to avoid the nondiscrimination rules and testing. They are suitable for a sole proprietorship with no employees and low income, less than would make sense for adoption of either a SEP or KEOGH plan. They are suitable in a multi-partner business where one partner wants a retirement plan and the other does not. They are suitable for an employer with low-paid employees or elderly employees who do not or cannot afford to save for retirement. They may be suitable for a parent employer who has a child working in the business and wants to use a SIMPLE IRA to save for college (although it is the child who owns the account).

SIMPLE plans are not suitable for an employer who has unstable cash flow or loses money on a more than occasional basis. SIMPLE matching or nonelective contributions are manditory. SIMPLE plans are not suitable if an employer has high turnover and the employees have no motivation to stay. Even the 25% penalty may not be enough to discourage turnover, and the employee can always wait until the two year period is up to quit. Vesting is full and immediate.
 

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Readers should be aware that nothing herein constitutes tax advice, and that individual situations vary. Taxpayers should consult with their tax advisors as to the applicability of rules their situation.