SIMPLE IRAs are popular retirement vehicles for small businesses. They are relatively cheap to adopt and are easy to understand and administer. However, that doesn’t mean problems do not arise. Routinely, we see issues involving ineligible plan sponsors, missed contributions, and late deposits. If you are thinking about adopting a SIMPLE IRA for your small business, it is essential that you understand the rules.
Establishing a SIMPLE IRA is simple enough. You execute a written agreement with a custodian that can either be a prototype plan, a Form 5304-SIMPLE, or a Form 5305-SIMPLE. You could also use an individually designed plan that meets the tax code requirements, but that is rare. Each eligible employee should receive a Summary Plan Description that not only complies with the IRS rules, but meets the Department of Labor standards under the Employee Retirement Income Security Act.
A SIMPLE IRA can be adopted by any type of business entity, all the way from a corporation down to a sole-proprietorship. However, there are two major qualification rules. First, the employer cannot have employed more than 100 employees who earned at least $5,000 during the preceding year. If an employer exceeds this limit, it can still maintain the SIMPLE IRA for two additional years. After that, the SIMPLE IRA should be frozen, and a new plan adopted. Second, the employer cannot sponsor any other retirement plan except the SIMPLE IRA.
When analyzing these rules, the employer should also consider the controlled group rules. These rules require certain companies and plans to be aggregated for tax purposes. Essentially, they prevent someone from creating two companies and placing the lower paid workers in one company and giving them little, if any, retirement benefit. Then in turn, placing the higher paid workers in a separate company and giving them a large retirement benefit, while at the same time, taking the employer deduction for employer contribution to retirement plans.
The controlled group rules can get complicated, and they do apply to SIMPLE IRAs. Basically, there are two types of controlled groups:
Parent-Subsidy: One company owns more than 80% of another company
Brother-Sister: Two companies have both Common Ownership and Identical Ownership
Common Ownership: 5 or fewer individuals own 80% or more of each company; and
Identical Ownership: the common owners have identical ownership of more than 50%
Making the matter even more complicated are the family attribution rules. These rules prevent someone from avoiding negative tax consequences by transferring ownership to certain family members. That means spouses, children, parents, and grandparents may all have one person’s ownership combined with their own when we apply these rules! When it comes to SIMPLE IRAs, these rules apply when we determine whether the employer has too many people to establish the SIMPLE IRA, whether they sponsor another retirement plan, and overall plan contributions.
SIMPLE IRAs allow both employee and employer contributions. Employees are eligible to defer the lesser of $12,500 or 100% of compensation. Those age 50 and older can make an additional catch-up contribution of $3,000. These limits are adjusted annually.
Unlike SEP IRAs and other qualified plans, SIMPLE IRA sponsors must make an employee contribution each year. The contribution must either be a matching contribution (up to 3% of compensation) or a 2% non-elective contribution. Basically, that means the matching contribution is only made to employees who actually contribute to the plan whereas the non-elective contribution is given to all eligible employees.
If the plan allows, the employer can switch contributions, but employees must be notified of the employer contribution before the upcoming plan year. One major difference between a SIMPLE IRA and non-IRA based qualified retirement plan (e.g., 403(b), 401(k), 457(b) plans); employer contributions are 100% vested. Employers cannot impose a vesting schedule like they can with other qualified plans.
SIMPLE IRAs offer employees greater flexibility than qualified plans, albeit not without consequences. Generally, qualified plans only allow distributions upon age 59 ½, death, disability, and termination of service. However, since SIMPLE IRAs are essentially individual IRAs, employees can request distributions at any time. These distributions will be taxable and could trigger the early distribution penalty. In fact, distributions that occur during the first two years of participation are subject to a 25% early distribution penalty if the individual is under age 59 ½! After the two-year period has been met, early distributions are subject to the normal 10% penalty.
Again, since we are dealing with an IRA, SIMPLE IRAs are subject to the IRA exemptions under the 10% early distribution penalty. Nevertheless, employees with a SIMPLE IRA can decide to take a distribution and pay the tax (however unwise that may be) whereas employees with other non-IRA based qualified plans may not even have that option.
Lastly, an employer must comply with the deposit rules. Salary reduction contributions must be made within 30 days after the end of the month in which the money would have otherwise been payable in cash. That means if someone has funds withheld from their payment on October 12, 2018, they must be deposited into the plan by November 30, 2018. For self-employed individuals, their salary reduction contributions do not have to be contributed until 30 days after the end of the plan year, or January 30th for calendar year plans. The employer contributions (i.e., the match or non-elective contribution) do not have to be made until the due date for the business’s tax return, including extensions.
In the end, SIMPLE IRAs are inexpensive and easy to administer retirement solutions for small businesses. However, before you take the plunge, make sure you understand all the rules and identify any potential pitfalls that are unique to your business.
By Jeremy T. Rodriguez, JD, IRA Analyst, Ed Slott and Company
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