Here are some frequently asked questions about the new SIMPLE IRA retirement plan. The answers to these questions could help you determine if this is the right plan for you and your business.
Q.What is a SIMPLE IRA retirement plan and what are its advantages?
A. This is a type of “salary reduction” retirement plan for small businesses. Due to its basic design features, it is not subject to the complex eligibility and testing requirements associated with traditional 401(k) plans or Salary Reduction-Simplified Employee Pension Plans (SRSEPs). Admin-istrative and other plan costs are therefore minimized.
Another advantage, from an employer’s standpoint, is that SIMPLE IRA plans are not subject to annual reporting and testing requirements. Also, the employer will not be subject to fiduciary liability resulting from an employee exercising control over the assets in his/her SIMPLE IRA account.
Q. Who can adopt a SIMPLE IRA plan?
A. Businesses are eligible to adopt a SIMPLE IRA plan if they employ 100 or fewer employees who each received at least $5,000 in compensation for the preceding year and do not maintain another employer-sponsored retirement plan. This includes corporations, partnerships, sole proprietors, tax-exempt organizations, and state or local governments or agencies.
Q. How does a SIMPLE IRA plan work?
A. It allows employees to make pre-tax elective contributions to a SIMPLE IRA. Employee contributions may be any percentage of their compensation (up to 100%), but may not exceed $6,000 per year (as indexed for inflation).
Also, employers must contribute to employee accounts using one of two contribution formulas: Under the matching contribution formula, employers are required to match employee contributions dollar for dollar up to 3% of each participating employee’s compensation.
(A special rule allows employers to elect a lower percentage matching contribution rate, but not less than 1% of each employee’s compensation. Employers may not elect to use a lower percentage for more than two out of any five consecutive years.)
Or, instead of making matching contributions, for any year, employers may select a non-elective contribution formula of 2% of compensation on behalf of each eligible employee and may, in addition, require that each such eligible employee actually receive at least $5,000 in compensation during the year, whether or not the employee made pre-tax elective contributions during the year.
For this purpose, compensation taken into account may not exceed $160,000 (as indexed for inflation).
The employer must give written notice specifying the employer’s contribution formula for a year to every eligible employee at least 60 days before the start of the year.
SIMPLE IRA contributions may only be made to a SIMPLE IRA account. Except for rollovers from other SIMPLE IRAs, no other contributions may be made (a SIMPLE can’t be combined with any other type of IRA).
Q. Who is eligible to participate in a SIMPLE IRA plan?
A. Generally, any employee who received at least $5,000 in compensation during any two prior years, and who is reasonably expected to receive at least $5,000 in compensation during the current year, is eligible. An employer may elect more liberal eligibility rules. All SIMPLE contributions (employee and employer matching) must be fully vested.
Q. How are SIMPLE IRA contributions treated for federal income tax purposes?
A. All SIMPLE IRA contributions are tax deductible for the employers. In addition, contributions to a SIMPLE IRA account are excluded from an employee’s income for federal income tax purposes in the year contributed, and the assets of a SIMPLE IRA account grow on a tax-deferred basis.
The employee’s pre-tax contributions are included in income for Social Security (both retirement and Medicare benefits) and unemployment taxes, if applicable. Thus, participation in a SIMPLE IRA plan will not reduce an employee’s Social Security benefits.
Q. How are distributions from a SIMPLE IRA plan taxed?
A. Generally, they are taxed under the rules applicable to IRAs. However, a 25% early distribution penalty applies to distributions taken prior to the two-year anniversary of initial participation, unless the employee is age 59 or older or another exception applies.
After the two-year period, the penalty tax rate is 10%. Tax-free rollovers may be made from one SIMPLE account to another.
Q. Can a SIMPLE IRA account be rolled over to an IRA?A.If two years have passed since the employee first participated in the SIMPLE IRA plan; your SIMPLE IRA may be rolled over to a traditional IRA on a tax-free basis. A SIMPLE IRA account may also be transferred to a Roth IRA if the employee’s modified adjusted gross income does not exceed $100,000.
However, any future employee and employer contributions under the SIMPLE IRA plan may only be made to a SIMPLE IRA account.
Toal is a financial advisor with Morgan Stanley Dean Witter. He can be reached at 800-488-4380.
Publication date: 09/04/2000