An IRA, or individual retirement account, is a retirement savings account that lets you contribute tax-deferred money toward retirement. The money isn’t taxed until you withdraw it at retirement. A SIMPLE IRA is an IRA plan that lets small business employers make contributions for their employees. Even self-employed workers can contribute their own SIMPLE IRA plan. Employees can make pre-tax contributions through salary reduction and employers can make matching contributions.
Rules for Establishing a SIMPLE IRA
To establish a SIMPLE IRA, the small business employer must have no more than 100 employees and they must have earned at least $5,000 in the previous year. All employees who worked during the previous year are included in the 100-employee limit. Employers generally are not allowed to have another qualified plan, like a 401(k) or 403(b) plan, in addition to the SIMPLE IRA, unless the qualified plan is targeted toward union employees.
Employers take three steps to establish a SIMPLE IRA plan.
1. The plan should be established using IRS Form 5305-SIMPLE, 5304-SIMPLE, or a prototype plan from a bank. The difference between the two IRS Forms is that the 5305 is used to establish a plan where all contributions will be made at the same bank while the 5304 allows employees to choose the bank for their contributions.
2. Eligible employees should be given information about the SIMPLE and the bank where contributions will be made. This information should be given to employees each year before the 60-day election period that usually starts on November 2 each year.
3. The SIMPLE IRA must be set up all employees that are eligible. The employee owns and controls their own SIMPLE IRA plan and the employer sends contributions to the bank that maintains the plan.
Businesses must maintain SIMPLE IRA plans on a calendar-year basis vs. fiscal year basis.
SIMPLE IRA Contribution Limits
Any employee can participate in the SIMPLE IRA plan as long as they earned at least $5,000 two years in the past and they expect to earn $5,000 this year. Employers can
choose to relax these conditions to allow more employees to participate. The employer can also choose to exclude union employees from participation in the SIMPLE IRA plan, especially if those employees have access to another retirement plan.
SIMPLE IRA Contribution Limits state that employees are allowed to contribute up to $11,500 in 2011. (This amount may adjust for cost-of-living 2012 and beyond.)
Employees who are at least age 50 can make an additional catch-up contribution up to $2,500. Employees are not allowed to opt-out of SIMPLE IRA participation. They can, however, choose not to make salary-reduced contributions for a particular year and would also not receive employer-matched contributions for that year. Employees receive employer non-elective contributions (explained below) whether they make contributions or not.
Employer Matched Contributions vs. Non-Elective Contributions
Employers are required to match employee salary reduction contributions dollar-for-dollar up to 3% of the employee’s compensation. If an employee contributes $2,000, the employer must also contribute $2,000. However, if the employee’s annual compensation is $40,000, the employer is only required to contribute 3% of the compensation amount, which is $1,200.
Alternatively, employers can choose to make a non-elective contribution of 2% of each employee’s compensation. If the employer makes non-elective contributions, it has to make them for all employees making over $5,000, even those who don’t’ make salary reduction contributions. Maximum compensation for SIMPLE IRA contribution consideration is $245,000.
Employers can temporarily reduce the percentage of the contribution that’s matched, but not below 1% and not more than 2 out of 5 years that the employee’s plan is effective.
SIMPLE IRA Withdrawals
Employees are allowed to start making qualified withdrawals from the SIMPLE IRA starting at age 59 ½. Employers can’t require employees to keep money in the SIMPLE IRA and they can’t make rules regarding withdrawals.
Premature withdrawals from the SIMPLE IRA are subject to the same penalty as early withdrawals from other types of retirement plans; exceptions apply too. However, if an early withdrawal is made during the first two years of employee’s participation in the SIMPLE IRA, the tax penalty is 25% instead of the 10% imposed on other early withdrawals. Withdrawals must also be included in the employee’s taxable income.