Fool.com: SIMPLE Retirement Plan - Part I
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SIMPLE Retirement Plan, Part I
Overview

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By Roy Lewis

Effective for tax years beginning after 1996, Congress added a significant incentive designed to help employees, particularly those of smaller companies, save for retirement on a tax-favored basis -- the SIMPLE plan (short for "Savings Incentive Match Plan for Employees"). I'll try to explain the basic features of a SIMPLE plan and why it might interest you, especially if you are self-employed or a small business owner or employee.

What Is a SIMPLE Plan and What Are Its Advantages?

A "SIMPLE" plan is a type of simplified retirement plan for small businesses. Because of its streamlined features, it is not subject to the complex qualification requirements associated with tax-qualified retirement plans. Administrative and legal costs, therefore, are minimized.

Other key advantages of SIMPLE plans, from an employer's standpoint, include that they are subject to simplified reporting requirements and that the employer (and any other plan fiduciary) will not be subject to fiduciary liability resulting from the employee or the employee's beneficiary exercising control (direction) over the assets in his or her SIMPLE account.

Who Can Adopt a SIMPLE Plan?

Your business is eligible to adopt a SIMPLE plan if it employs 100 or fewer people who earned at least $5,000 in compensation for the preceding year, and does not maintain another employer-sponsored retirement plan. If your business is eligible to establish a SIMPLE plan but later becomes ineligible, your company will have a two-year grace period during which it can continue to maintain the plan. And, to be sure, self-employed people -- even if they have no employees -- are still eligible to open a SIMPLE plan.

How Do SIMPLE Plans Work?

A SIMPLE plan allows employees to make elective contributions to an individual retirement account (IRA). Employee contributions must be based on a percentage of their compensation and cannot exceed $6,000 per year (which is indexed for inflation). As an employer, your business would have to satisfy one of two contribution formulas:
  1. Under the matching contribution formula, your company generally would be required to match employee contributions dollar-for-dollar up to 3% of each participating employee's compensation. A special rule allows you to elect a lower percentage matching contribution for all employees (but not less than 1% of each employee's compensation). You cannot, however, elect to use a lower percentage for more than two out of any five years.

  2. Instead of making matching contributions, your company could elect to make a 2% contribution on behalf of each eligible employee who earns at least $5,000 in compensation for the year.
Example: You are a business owner with two eligible employees. Employee Mary makes $30,000 per year and elects to contribute 5% of her annual salary (or $1,500) to the SIMPLE plan. Your employee Sam, who is an eligible employee with an annual salary of $40,000, decides that he does not want to make any contributions to the SIMPLE plan. You, as the employer, have a number of options regarding matching contributions:
  1. You can elect to match Mary's contribution, up to 3% of her wages. If you elect this method, your contribution match would amount to $900.00. Since Sam doesn't participate in the SIMPLE plan, you are not obligated to make any contribution on his behalf.

  2. You can match Mary's contribution at a rate less than 3% (but not less than 1%). But, remember that this lesser match cannot be used more than two out of any five years. So, if you decide on the lesser match, you'll have to keep an eye on the calendar. As in the first option, you are not required to make any SIMPLE contributions on behalf of Sam. But, you should also know that this option is not available for SIMPLE 401(k) plans.

  3. You can choose to make non-elective contributions of 2% for all eligible employees. In this case, you would owe a contribution of $600 on behalf of Mary (2% of her wage base of $30,000) and you would also owe a contribution of $800 on behalf of Sam (2% of his wage base of $40,000). Even though Sam is not participating in the SIMPLE plan, if you decide to go with the 2% non-elective contribution option, you are obligated to cover each and every eligible employee... even if that employee is not making any wage deferrals.
So, your choice will be predicated on how many employees you have, how many of them participate, their wage base, your employee turnover, etc. But, the nice thing is that each year's matching contribution is available for that year only, and can be changed for the following year. Your options are completely flexible from year to year.

And, you must remember that no contributions other than employee elective contributions and required employer-matching contributions (or, if option #2 above is elected, required employer contributions) can be made to a SIMPLE plan.

Who Is Eligible to Participate in a SIMPLE Plan?

Generally, any employees who received at least $5,000 in compensation from your company during any two prior years and who are reasonably expected to receive at least $5,000 in compensation from your company during the current year must be eligible to participate in the SIMPLE plan. Self-employed individuals can also participate. All contributions to an employee's SIMPLE account must be fully vested.

There is no limitation on the percentage of salary that the employee can elect to defer, just on the dollar amount per year. If an eligible employee has a salary of $6,000, s/he can elect to defer 100% of that salary. This won't have any impact on the employer contributions, but it gives the employee substantial flexibility regarding the amount of compensation to defer (up to the $6,000 maximum limitation).

Consider the benefit to those of you who may employ family members, such as your younger children. What if they decide to defer a large percentage of their wages? You, as their employer, receive the tax deduction for their wages and the matching contributions that you are required to make, and the employee/relative has no substantial income on which personal income taxes have to be paid. For many of you who employ family members, this technique could really help you hit the jackpot.

In Part II, we'll close out our discussion of the SIMPLE plan. And, of course, if you have any questions or comments on anything that you read here, you can post a question in the Tax Strategies discussion board.
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