How are contributions to a SIMPLE plan taxed?
As an employer, within limits, your contributions to an employee's SIMPLE account generally are deductible. However, matching contributions are deductible in a given year only if they are made by the due date (including extensions) for your company's federal income tax return. Contributions to a SIMPLE account are excludable from employees' income and the assets of a SIMPLE account, like those of a qualified retirement plan, grow tax-deferred.
How are distributions from a SIMPLE plan taxed?
Distributions from a SIMPLE plan generally are taxed under the rules applicable to traditional IRAs, and tax-free rollovers can be made from one SIMPLE account to another. A SIMPLE account can be rolled over to a traditional IRA on a tax-free basis after a two-year waiting period that starts the day the individual first became a participant in the SIMPLE plan. If an employee is no longer participating in a SIMPLE plan (e.g., the employee has terminated employment), and two years have passed since the employee first participated in the SIMPLE plan, the employee's SIMPLE account is treated as a traditional IRA.
Do early withdrawal penalties apply to SIMPLE plans?
Yes. Early withdrawals by an employee from his or her SIMPLE account generally are subject to the 10% early withdrawal penalty applicable to IRAs. Additionally, if the withdrawals are made during the two-year waiting period that begins on the date that the employee first became a participant in the SIMPLE plan, the early withdrawal penalty increases to 25%.
Are employer contributions to a SIMPLE plan subject to employment taxes?
No. Employer-matching and non-elective contributions to a SIMPLE account are not subject to employment taxes when made. This means that you can make matching contributions for your employees free from employment taxes such as FICA and Medicare. But, if you are self-employed and file a Schedule C, you should know that any and all matching and/or non-elective contributions that are made to your own personal SIMPLE plan account are subject to self-employment taxes. So, the tax treatment for your employees is a bit different than it is for you as the self-employed business owner.
What rules apply to employees' contributions to a SIMPLE plan?
An eligible employee can elect, within the 60-day period before the beginning of any year (or the 60-day period before first becoming eligible to participate), to participate in the employer's SIMPLE plan and to modify any previous elections regarding the amount of contributions.
As an employer, you are required to contribute employees' elective deferrals to their SIMPLE accounts within 30 days after the end of the month to which the contributions relate.
Employees must be allowed to terminate participation in the plan at any time during the year. A SIMPLE plan can provide that an employee who terminates participation cannot resume participation until the following year.
A SIMPLE plan also can permit an individual to make other changes to his or her salary reduction contribution election during the year. Your company might designate a SIMPLE account trustee to which contributions on behalf of eligible employees are made.
Can SIMPLE Plans operate in 401(k) plan form?
Yes. Generally, a 401(k) plan satisfies the special nondiscrimination tests applicable to employee deferrals and employer matching contributions if the plan satisfies the contribution requirements applicable to SIMPLE plans, including the safe harbors described above and the $6,000 contribution limit. (Again, remember that the $6,000 contribution limit is indexed for inflation, so it will change over the years.)
One exception with a 401(k) plan is that the employer cannot reduce the optional matching percentage contribution below 3%. For a 401(k) plan to qualify under the SIMPLE plan rules, the employer also cannot maintain another qualified retirement plan for the year.
What if your business currently maintains a SARSEP?
The SIMPLE plan replaces the Salary Reduction Simplified Employee Pension plans (SARSEPs) that are still in existence for certain small employers under current law. If your business established a SARSEP before January 1, 1997, it can continue to make contributions under the old SARSEP rules. Employees hired after December 31, 1996, can become participants in such pre-existing SARSEPs and be covered under the old rules, too.
A business, however, cannot establish a new SARSEP. Furthermore, since a SARSEP is a type of employer-sponsored retirement plan, an employer cannot maintain both a SARSEP and a SIMPLE plan.
SARSEPs, like SIMPLE plans, are subject to simplified qualification, administration, and reporting requirements. Even if your business currently qualifies to maintain a pre-existing SARSEP, however, you might want to consider switching to a SIMPLE plan, depending on the circumstances. For instance, although it is now possible, under certain limited circumstances, for SARSEPs to permit employees to defer a greater dollar amount than SIMPLE plans, this advantage will go away as the $6,000 employee contribution limit is indexed for inflation.
Also, SARSEPs are subject to special nondiscrimination testing, are limited to employers with 25 or fewer eligible employees, and pre-existing SARSEPs only remain available if 50% or more of the eligible employees elect to participate. SIMPLE plans are not subject to these constraints.
I hope my little discussion has given you an idea about the basics of SIMPLE plans and their potential as a cost-effective, easy-to-administer retirement savings arrangement for you and/or your employees. If you would like to read more about SIMPLE plans, check out IRS Publications 560 and 590 at the IRS website. And, if you would like to discuss SIMPLE plans in greater detail, you can always visit the Tax Strategies discussion board.