Module 4: SIMPLE IRAs

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In 1996, Congress permitted smaller employers to offer a Savings Incentive Match Plan for Employees (SIMPLE plan) as a way to encourage retirement savings. SIMPLE plans, which may be structured as an IRA or 401k plan, allow employees to make “elective” contributions to their retirement account. Employers must match employee contributions. Assets in the account grow tax-deferred and are taxed when they are eventually distributed to an employee. Employers may generally deduct contributions to employees’ accounts as a business expense. To encourage adoption of these plans, Congress exempts SIMPLEs plan from the need to perform complex nondiscrimination testing and to comply with burdensome top-heavy plan and reporting rules.

Unlike other qualified plans, SIMPLE plans are not available to all employers. First, only employers who do not have any other qualified retirement plans may set up a SIMPLE plan.* Secondly, only employers who have 100 or fewer employees may establish a SIMPLE plan. When counting employees, the employer must include all employees employed at any time during the year, regardless of whether those employees were eligible to participate in the plan.** Businesses that operate under common control are treated as a single employer. Thus, the employees of two businesses under the control of a sole proprietor would be combined for purposes of determining whether either business could establish a SIMPLE plan. Likewise all employees of a parent company and subsidiary must be counted to determine if a SIMPLE plan can be established.

Existing employers wishing to establish a first-time SIMPLE plan may do so on any date between January 1 and October 1. New employers that come into existence after October 1 may set up a SIMPLE plan for that year provided it is established as soon as is administratively feasible. Employers that previously maintained a SIMPLE plan, may establish a SIMPLE plan effective only on January 1 of a year.

Employers who maintained a SIMPLE plan for at least one year, but are ineligible in subsequent years, may continue to maintain the plan for an additional “two-year grace period” following the last year of employer eligibility. If the employer remains ineligible after the two-year grace period, the SIMPLE plan may no longer be maintained.

Example: Stellar Corporation is a rapidly growing business. It established a SIMPLE plan in 2005 when it had 95 employees. In early 2007 it hired its 101st employee, and it is no longer eligible for a SIMPLE plan. However, it may maintain its plan for the next two years under the grace period. If at the end of the grace period its payroll drops to less than 100 employees, it may continue to operate the plan. If not, no SIMPLE plan contributions may be made in future years.

A special rule applies to mergers and acquisitions. If an employer becomes ineligible for a SIMPLE plan due to a merger, acquisition or similar restructuring, the SIMPLE may be maintained for the rest of the year and the year following the restructuring.

Example: ABC Corporation operates a SIMPLE IRA plan for its 35 employees. XYZ, Inc. maintains a defined benefit plan for 47 employees. ABC merges with XYZ in August 2007. Since the combined enterprise has another type of qualified plan, it is no longer eligible for a SIMPLE plan (even though it has fewer than 100 employees). The tax code allows ABC to continue operation of the SIMPLE IRA for 2007 and 2008. However, during this time, XYZ's employees may not participate in the SIMPLE IRA and participants in ABC's SIMPLE plan are not eligible for the pension plan.

Employers may adopt a SIMPLE plan as part of a 401k arrangement or establish the SIMPLE plan using employee IRAs. They are similar in concept, but differ in some aspects of their operation. The following discussion focuses on SIMPLE IRA plans — but will note differences between SIMPLE IRAs and SIMPLE 401ks: highlighted with [§ ].

Of the two, the SIMPLE IRA is easier to establish. The IRS has a model SIMPLE IRA document that employers may use to set up the program. To set up a SIMPLE IRA plan, the employer simply completes Form 5305-SIMPLE, a two-page document. In addition, the employer must notify eligible employees of their coverage by the plan and ensure that an IRA account has been established by each eligible employee. Contributions to the plan are then deposited in the employees’ IRAs. The employer will claim a tax deduction for contributions under a SIMPLE plan. All IRAs established under a SIMPLE arrangement must be traditional IRAs, not Roth IRAs. All eventual distributions from the account will be fully taxable to the employee, and are subject to the same restrictions as traditional IRAs. [§ SIMPLE 401ks allow a Roth account to accept employee after-tax deferrals, however, employer 401k contributions must be placed in a regular, “non-Roth” account.]

To establish a SIMPLE 401k plan, the employer must conform to the requirements of a regular 401k plan — which is more complicated than setting up a SIMPLE IRA. The employer may establish a new SIMPLE 401k plan or “convert” an existing 401k plan into a SIMPLE 401k by agreeing to operate under the SIMPLE rules. The advantage of a SIMPLE 401k plan is that the complex nondiscrimination tests for “regular” 401ks are satisfied if the plan meets the SIMPLE contribution and vesting requirements. SIMPLE 401k plans, however, the must satisfy all of the other, somewhat complicated rules governing 401ks — SIMPLE IRAs do not. [§ SIMPLE 401k plans may permit loans to plan participants and withdrawals for financial hardship, SIMPLE IRAs may not.]

All SIMPLE plans — 401k or IRA — must be maintained on a calendar year basis. If an employer “converts” an existing 401k plan that is maintained on a fiscal year basis into a SIMPLE 401k, the plan must be converted to a calendar year in order to adopt the SIMPLE arrangement.

Eligible employees need only have earned $5,000 in compensation in any two preceding years and not in the immediately preceding two years. Nor must the two years be consecutive. In addition, an employer may establish a SIMPLE plan even if none of its employees wish to participate, although the employer must notify employees of their right to participate in the plan. Self-employed individuals are eligible to participate in a SIMPLE plan, as are employees who may participate in a retirement plan of a different employer for the same year.

Employers may choose to make the participation requirements of their SIMPLE IRA less restrictive. In fact, employers may waive the compensation rule altogether and simply cover all employees. The employer's decision is indicated by filling the appropriate amounts in the spaces indicated on Form 5305-SIMPLE. [§ SIMPLE 401k plans may limit participation to those age 21 and older, SIMPLE IRAs may not.]

In some situations, employers may exclude nonresident aliens and employees who are covered under a collective bargaining agreement from participation the SIMPLE plan. (Although these employees are counted for purposes of qualifying under the 100 employee rule.) The employer’s decision regarding these employees is indicated by simply checking the appropriate boxes on Form 5305-SIMPLE for SIMPLE IRAs.

Under the SIMPLE plan, an employee can elect to contribute up to $9,000 per year (adjusted for inflation, $10,500 in 2007). The contribution formula in a SIMPLE plan is expressed as a percentage of compensation, not as a flat dollar amount, so not every employee may be able to contribute the maximum. Participants aged 50 or older may contribute an additional $2,500 per year as a “catch-up” provision (adjusted annually for inflation).

Any employee contribution to a SIMPLE plan counts toward the employee's maximum annual elective deferrals that applies cumulatively to all SIMPLEs, SARSEPs, “regular” 401ks or tax-sheltered annuities the employee may participate in. This maximum annual limit is $15,500 in 2007 (adjusted annually for inflation).

Please note: the $10,500 maximum contribution to a SIMPLE IRA significantly exceeds the $4,000 annual contribution limit for "regular" IRAs in 2007. [ § The opposite is true of SIMPLE 401ks — the SIMPLE limit is less than for “regular” 401ks: $15,500 in 2007.]

Under the matching contribution formula, employers match a participating employee's contributions on a dollar-for-dollar basis, up to a maximum of 3% of the employee's compensation for the year. For SIMPLE IRAs, an employee's actual, total compensation is used to calculate the maximum matching contribution. [§ SIMPLE 401ks must limit the amount of compensation used to calculate matching contributions: a maximum of $225,000 in 2007.]

As an alternative, employers may choose to match contributions for a given year at a rate less than 3% — but no lower than 1% — of each employee's compensation. In these cases, the employer must notify employees of the lower percentage within a reasonable time before the 60-day election “window” during which employees decide whether to participate in the SIMPLE IRA plan (see below). In addition, the employer may not choose a lower percentage if that would cause the matching percentage to drop below 3% of employee compensation in more than two of the past five years. [§ This alternative is not available to employers with SIMPLE 401k plans].

For example, Samantha’s unincorporated catering business, Goodies on the Go, employs Hannah, Chris and Jack as employees — each is paid $50,000. Samantha’s net business income is $250,000.

Assume Goodies on the Go sets up a SIMPLE IRA. Hannah elects to defer 5% of her compensation, Chris elects 1%, Jack chooses not to defer anything in 2007, while Samantha elects to defer 4% of her business income. Matching contributions to the participants’ IRA would be:

For Hannah: Elective deferral Matching contribution	5% of $50,000 or 3% of $50,000 or	$2,500 $1,500	$4,000
For Chris: Elective deferral Matching contribution	1% of $50,000 or dollar-for-dollar or	$ 500 $ 500	$1,000
For Jack Elective deferral Matching contribution	0% of $50,000 or dollar-for-dollar or	$ 0 $ 0	$ 0
For Samantha: Elective deferral Matching contribution	4% of $250,000 or 3% of $250,000 or	$10,000 $ 7,500	$17,500

If Samantha’s income had been $300,000, a 4% elective deferral would exceed the maximum of annual amount ($10,500 in 2007), so her elective deferral would be capped at $10,500 and the matching contribution would be $9,000 (3% of $300,000)

A matching contribution formula requires a contribution each year. Employers cannot simply choose to not contribute in some years due to financial difficulties or other reasons. If the employee chooses to defer income, the employer must match it (to some extent).

Under the nonelective formula, an employer simply contributes 2% of the compensation for each eligible employee that year. When calculating nonelective contributions to a SIMPLE IRA, employee compensation is limited to the first $150,000 of income — adjusted for inflation ($225,000 in 2007). Please note: the matching contribution formulae above refer to participating employees, i.e., those who choose to defer income into their SIMPLE IRA account. The nonelective formula applies to all eligible employees, whether they choose to contribute or not. The employer must contribute 2% of all eligible employee’s compensation to the SIMPLE plan. The employer must notify each eligible employee of the nonelective contributions before the 60 day election period during which an employee decides whether to participate in the SIMPLE plan.

Assume the same facts as the previous example: In 2007, Hannah, Chris and Jack are each paid $50,000. Samantha’s net business income is $250,000. Hannah elects to defer 5% of her compensation, Chris elects 1%, Jack chooses not to defer anything in 2007, while Samantha elects to defer 4% of her business income. Goodies on the Go chooses the non-elective method in 2007. The non-elective contributions to the participants’ SIMPLE IRA would be:

For Hannah: Elective deferral Non-elective contribution	5% of $50,000 or 2% of $50,000 or	$2,500 $1,000	$3,500
For Chris: Elective deferral Non-elective contribution	1% of $50,000 or 2% of $50,000 or	$ 500 $1,000	$1,500
For Jack Elective deferral Non-elective contribution	0% of $50,000 or 2% of $50,000 or	$ 0 $1,000	$1,000
For Samantha: Elective deferral Non-elective contribution	4% of $250,000 or 2% of $225,000 or	$10,000 $ 4,500	$14,500

The annual contribution limit and the requirement of an annual contribution may make SIMPLE plans less attractive to small employers. For example, the owner of a small business whose income is much higher than that of her employees and who is interested in compiling retirement assets for herself as quickly as possible, may prefer to adopt a more traditional qualified plan (such as a Keogh plan) that allows higher annual contributions. In addition, small businesses that have fluctuating profits should be aware that they must continue to make contributions to the SIMPLE IRA even if the business is not performing well in that year. Even in lean years, an employer will be required to match at least one-percent of its employees’ compensation. A SEP plan, which does not mandate annual contributions, would be a more flexible option.

Employers may deduct any contributions they make to the SIMPLE account for the year in which they are made. This includes a deduction for the employee's compensation that was “deferred into the account”, i.e., the employee's elective contributions. Employers may take a deduction for matching contributions to a SIMPLE plan for the tax year, provided the contributions are made by the date that the employer's tax return is due (including extensions).

All contributions (elective employee deferrals and employer matching or non-elective contributions) to the SIMPLE account are excluded from an employee's income for federal income tax purposes. Employee contributions to a SIMPLE IRA are subject to Social Security/Medicare (FICA) and federal unemployment taxes (FUTA). Employer contributions to a SIMPLE IRA, however, are not subject to federal payroll taxes.

Eligible employees participate in a SIMPLE plan by making elective deferrals. This is similar to a salary reduction program — the employee chooses to contribute a portion of his or her before-tax earnings into the SIMPLE plan. The IRS requires a minimum 60-day window in which employees may elect to contribute to a SIMPLE plan. Typically the “window” is the 60-day period before January 1st. SIMPLE plans may expand this window — some plans offer up to 90 days in which to decide, others may offer a 30-day window each quarter. Employees must decide if they will contribute to the plan during that "window" of opportunity — or if they wish to modify the amount they previously elected.

Employers must notify their employees of their eligibility to contribute to the SIMPLE plan. In SIMPLE IRAs, the notice form is part of Form 5305-SIMPLE. The notice indicates what type of employer contributions will be made for the upcoming year (matching vs. non-elective). All notices must be provided within a reasonable period of time before the start of the period in which employees choose to contribute. Employees respond to the notice indicating if they wish to contribute elective deferrals, and if so, how much.

Employees may terminate their participation in the SIMPLE plan by discontinuing their contributions — at any time during the calendar year. However, the employer can restrict an employee from resuming participation until the beginning of the following year.

The monies contributed by employees to a SIMPLE must be segregated from the employer's assets as quickly as possible. IRS regulations require employers to deposit employee contributions into the employee’s SIMPLE IRA within 30 days of the end of the month. In the event that an eligible employee is unwilling or unable to establish a SIMPLE IRA prior to the expiration of the 30 day period during which a contribution must be made, the employer may establish a SIMPLE IRA on the employee's behalf with a financial institution selected by the employee.

All contributions to an employee’s SIMPLE account must be nonforfeitable, that is, every contribution is immediately, 100% vested. Similarly, amounts held in a SIMPLE IRA may be withdrawn without restriction (other than general IRA rules) at any time.

Distributions from a SIMPLE IRA are generally taxed like distributions from a traditional, deductible IRA. Distributions are fully taxable when the participant withdraws funds from the account, premature distributions are subject to a 10% penalty tax, minimum distributions must begin no later than age 70½., etc.

In addition to these general IRA rules, SIMPLE IRAs impose a special, two-year restriction on distributions. [§ These restrictions do not apply to SIMPLE 401ks]. Participants who withdraw funds during their first two years of participation face a 25% penalty tax on premature distributions. This is in addition to the income taxes owed on the distribution. The 25% tax does not apply to withdrawals made after age 59½, due to death or disability, or any of the other exceptions for premature distributions. After the first two years, the penalty tax reverts to the usual 10% for premature distributions from IRAs.

During the first two years of an employee’s participation, a distribution may be rolled over only from one SIMPLE IRA to another SIMPLE IRA. During the first two years, rollovers to other types of IRAs are subject to the 25% penalty. After the two-year period, a participant may roll a distribution over from a SIMPLE account to a “regular” IRA without penalty. The penalty also applies to direct trustee-to-trustee transfers to non-SIMPLE IRAs in the first two years.

Assets held in a SIMPLE IRA may be rolled over into other types of qualified plans, 403(b) tax sheltered annuities and deferred compensation plans of state or local governments (section 457 plans). The trustee must disclose the procedures for rolling over distributions from the SIMPLE account in the plan summary provided to the employee.

Trustees of SIMPLE plans and employer’s maintaining these plans are not required to meet the complex reporting requirements of ERISA. SIMPLE plans impose a streamlined reporting regimen on trustees and employers. This is one of the key advantages of a SIMPLE plan over other qualified retirement accounts. Trustees of SIMPLE IRAs (and issuers of annuities within SIMPLE IRAs) are only required to provide employers with a summary description of plan requirements and procedures. In addition, they must provide an annual account statement to each individual for whom a SIMPLE account is maintained. Employers (not trustees) must provide a copy of this summary description prepared to their employees. Employers must also notify employees, annually, of their opportunity to participate by making a salary reduction contribution.

In addition, the summary description must disclose the procedures for, and effects of, rolling over distributions from a SIMPLE account. Trustees should provide the summary description sufficiently early, so employers may meet their notification obligation to employees.

For SIMPLE IRAs that were established using of Form 5305-SIMPLE, the trustee may satisfy its reporting obligation by providing the employer with a current copy of Form 5305-SIMPLE with instructions, the information required for completion of Article VI of the form regarding the withdrawal of contributions by employees, and the name and address of the financial institution holding the SIMPLE plan contributions. The trustee should inform the employer of the need to fill out the first two pages of the form and to distribute completed copies to eligible employees. Trustees of a transfer SIMPLE IRA need not provide a summary description.

The trustee of the SIMPLE plan must also provide an account statement to each individual for whom the SIMPLE account is maintained by January 31 each year. The statement must reflect the account balance as of the close of the calendar year and account activity during the year. Trustees will also file information with the IRS annually, including contributions, rollovers and fair market value of the account. Trustees will also report any distributions from a SIMPLE IRA and whether a distribution occurred during an individual's first two years of participation in the SIMPLE plan.

Employers maintaining a SIMPLE plan are not required to file annual reports with the IRS. However, employers must notify each employee of the employees’ right to make salary reduction contributions under the plan, of the contribution alternative elected by the employer, and, of the employee's right (if applicable) to select the financial institution that will serve as the trustee of a SIMPLE IRA. The notice must include a copy of the summary description prepared by the trustee for the employer and must be provided immediately before the 60-day period during which an employee may make an election. If a SIMPLE IRA was established using Form 5305-SIMPLE, the employer may simply provide the first two pages of the completed form, instead of the summary description.

Generally, an employer must allow an employee to select the financial institution that will hold the contributions to the SIMPLE IRA. However, under certain circumstances, an employer may require that all contributions be made to a trustee chosen by the employer. In either event, the financial institution must permit the participant's account to be transferred without cost or penalty to another SIMPLE IRA. (Or, after the employee has participated in the plan for two years, to any other IRA selected by the participant). In addition, each participant must receive written notice of the procedures, including any time restrictions, that apply to a transfer.