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 A SIMPLE IRA is a plan that gives smaller employers an easy way to contribute towards an employee's retirement account. The SIMPLE IRA allows the employee to make salary-reduction contributions and employers make matching contributions. In this article we're going to discuss the benefits, eligibility rules, how to set up a SIMPLE IRA, as well as contributions and withdrawal rules.
What is a SIMPLE IRA?
An easy way to think about SIMPLE IRAs is this - they are very much like 401k plans for small businesses. A SIMPLE IRA gives small employers the chance to provide their employees with a retirement plan that allows for contributions by employees as well as employers. Employees make contributions through what are called salary reductions, while employers can make matching non-elective contributions.
Setting Up a SIMPLE IRA
The rules for setting up a SIMPLE IRA are pretty straightforward. There are only two rules that apply to any employer that wants to set up a SIMPLE IRA plan.
- The first rule is that the employer must have 100 or less employees that received compensation of at least $5,000 in the prior calendar year.
- The second rule is that the employer cannot maintain another qualified plan - such as a 401k plan or 403b plan - unless that plan is targeted to a bargaining union workforce.
SIMPLE IRA Eligibility / Participation Rules
The participation rules for employees are even simpler. An employee is eligible to participate in a SIMPLE IRA if they have received at least $5,000 in annual compensation at least twice in the past, and is expected to be paid at least $5,000 in the current year. The employer has the discretion to have less restrictive requirements if they choose to do so.
Employees that are covered by a collective bargaining agreement, and have specifically bargained for retirement benefits, can be excluded from the employer's SIMPLE IRA plan.
Employers Establishing a SIMPLE IRA
The IRS provides employers with a lot of guidance when it comes to setting up a SIMPLE IRA. Most large financial institutions can supply employers with a SIMPLE IRA plan document that they can adopt. In addition there are three steps all employers must take:
- Employers need to establish a SIMPLE IRA plan by adopting an IRS model based on Form 5305-SIMPLE or Form 5304-SIMPLE. Most large financial institutions or banks can provide a prototype plan that employers can use.
- Employers need to provide all eligible employees with information about their SIMPLE IRA plan - the rules of the plan. They also need to provide information about where the money will be deposited. This information must be provided annually to employees during the election period, which is typically 60 days prior to January 1st.
- IRS Form 5305-S (trustee account) or Form 5305-SA (custodial account) must be used to provide each eligible employee a SIMPLE IRA account. This is because SIMPLE IRA accounts are owned and controlled by the employee. Employers need to send contributions directly to the bank, insurance company, or financial institution maintaining the account.
SIMPLE IRA Contributions
Employees participating in a SIMPLE IRA plan may defer up to $10,000 per year starting in 2006. Employees that are age 50 or over are also eligible to make catch-up contributions of $2,500 starting in 2006.
In 2007 and 2008, the contribution limits for SIMPLE IRAs increase to $10,500 and will increase by the cost of living in the years 2009 and beyond. Catch-up contributions in 2007 and 2008 remain at $2,500.
With SIMPLE IRA plans, the employee makes a voluntary or "elective" deferral that count not only in the employer's plan, but also towards any other elective plan in which the employee participates.
Employer Matching
Employers are generally required to match the employee's contribution on a dollar-for-dollar basis, up to 3% of the employee's compensation. Employers may also elect to make "non-elective" contributions equal to 2% of the employee's annual compensation. In 2006, this non-elective, 2% contribution was limited to $220,000 in compensation. That means the employer was limited to a non-elective contribution of $4,400 in 2006.
In 2007, the employee compensation limit increases to $225,000, translating into $4,500 in employer contributions. And in 2008 the compensation limit increases to $230,000, translating into $4,600 in employer contributions. These contribution limits are expected to continue to grow with the cost of living in 2009.
If an employer decides to make these non-elective contributions, then they are required to make them on a non-discriminatory basis. That means all employees making $5,000 or more in annual compensation will be eligible for these 2% contributions. Employers may deduct all contributions made to their employees' SIMPLE IRAs on their income tax return
SIMPLE IRA Withdrawals
Qualified distributions or normal withdrawals from a SIMPLE IRA can start at age 59 1/2. And an employer cannot require an employee to keep any portion of their contributions in their SIMPLE IRA account. Employers are also not allowed to introduce any plan-specific withdrawal rules.
SIMPLE IRA Withdrawal Exceptions
SIMPLE IRAs follow the same withdrawal rules that apply to traditional IRAs - including exceptions. But there is a rule that is called the "2-year period" rule that is unique to SIMPLE IRAs.
The 2-year period begins on the date on which the employee first participated in any SIMPLE IRA plan maintained by their employer. If an employee takes an early distribution within this 2-year period, then the additional tax penalty is raised from 10% to 25%. However, if one of the exceptions mentioned earlier applies to these early withdrawals, then the 25% tax penalty is not imposed.
For more information on the SIMPLE IRA distribution rules as well as exceptions from these rules, take a look at our article on IRA Withdrawals.
SIMPLE IRA Rollovers
As is the situation with IRA rollovers, most rollovers from a SIMPLE IRA plan are not considered taxable distributions. SIMPLE IRA rollovers are also subject to a two-year rule. This means that beginning on the first day that a deposit is made into a SIMPLE IRA plan, the employee must wait two years before the SIMPLE IRA can be rolled-over into any other qualified plan, such as a 403(b), 401(k) or another IRA. If the employee wants to make a tax-free rollover before the two year rule has expired, then the transfer must be to another SIMPLE IRA account.
An early distribution that does not satisfy the rollover rules above is subject to an extra 10% tax on the distribution. If the two year rule is not satisfied and the distribution is taxable, the additional tax is increased to 25%.
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