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 can make matching contributions. In this article, we're going to discuss the benefits, eligibility, how to set up a SIMPLE IRA, as well as contributions and withdrawal rules.
What is a SIMPLE IRA?
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An easy way to think about SIMPLE IRAs is this: They are very much like 401(k) 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
Setting up a SIMPLE IRA is straightforward; there are only two rules that apply to any employer that wants to set up a plan.
The first rule is 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 the employer cannot maintain another qualified plan, such as a 401(k) plan or 403(b) plan, unless targeted to a bargaining unit workforce.
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.
Employer Obligations
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 plan document that they can use as a template. 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 concerning 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
In 2021, the contribution limit for SIMPLE IRAs remains $13,500, the same as 2020. This value can increase by the cost of living in the years 2022 and beyond. Catch-up contributions in 2020 and 2021 remain at $3,000. With SIMPLE IRA plans, the employee makes a voluntary or "elective" deferral that counts 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 decide to make "non-elective" contributions equal to 2% of the employee's annual compensation. In 2020, this non-elective, 2% contribution was limited to $285,000 in compensation. That means the employer was limited to a non-elective contribution of $5,700 in 2020. In 2021, the employee compensation limit increases to $290,000, and a non-elective contribution of $5,800 in employer contributions. These limits are expected to continue to grow with the cost of living in 2022. 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 payments 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. An employer cannot require an employee to keep any portion of their contributions in their account. Employers are also not allowed to introduce any plan-specific withdrawal rules.
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 this type of retirement plan. 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, take a look at our article: IRA Withdrawals.
Rollovers
As is the situation with IRA rollovers, most transfers 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 investment 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 penalty increases to 25%.
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