Short-term Decisions, Long-term Outcomes
A SIMPLE IRA is inexpensive, fast to establish and relatively easy maintain. For these reasons, it is often a go-to plan for small businesses. Yet, a SIMPLE IRA may fall short of satisfying long-term needs for retirement accumulation, income tax management in the accumulation years, and tax diversification in retirement. Let’s review its key features, benefits, potential shortcomings, and alternatives.
Participation Rules In its strictest form, a SIMPLE IRA has to be available to any employee who (1) earned at least $5,000 during any two years preceding current calendar year and (2) is expected to earn at least $5,000 in the current year. Union employees and nonresident alien employees without US compensation may be excluded from the plan. That’s it.
Unlike in a 401(k) plan where an employee may be required to be age 21 and complete one year of service (12 months/ 1,000 hours), age and hours of employment are not included in eligibility considerations, making SIMPLEs less attractive for businesses with a large part-time employee population.
Contribution Rules SIMPLEs are funded from two sources, employee salary deferrals and company contributions. Plan participants may save up to $12,500 ($15,500 if age 50 or older) or 100% of compensation, whichever is less.*
Employer has to options: either flat 2% of compensation contribution to all eligible employees, or a dollar-for-dollar match up to 3% of pay for employees who save.
The contribution type and amount for each upcoming year must be decided and communicated to participants annually by November 2. When business owner is interested in saving more than $15,000 – $20,000 per year, it’s time to consider a plan upgrade.
An Exclusive Plan Rule ‘Gotcha’. When a company has a SIMPLE IRA, it has to be the only plan maintained in the calendar year; it may not be stopped in favor of another plan, no matter how robust or advantageous to participants. This rule prohibits businesses with SIMPLEs, and related employers, from installing complementary plans to increase savings. Alternative plan arrangements, a 401(k) for example, allow the use of add-on plans such as a profit sharing or a cash balance plan. These plan combinations increase the deductible contribution potential above the limits possible with a stand-alone 401(k).
For example, a 401(k) profit sharing plan improves on the contribution limits of SIMPLEs in two ways. First, the salary deferral limits are substantially higher, allowing deferrals of $18,000 plus a $6,000 catch-up for those 50 or older. In other words, a 401(k) plan offers an instant contribution increase of $5,500 – $8,500.
Next, when looking at employer contributions, the new deductible limit increases from 3% of pay SIMPLE IRA ceiling to 25% of total plan compensation. Employer contribution amounts may be decided up to the date of employer’s tax filing including extensions. In other words, the profit sharing component delivers both the higher limits and the ability to determine the level of contributions with perfect hindsight. The total 401(k) profit sharing contribution limit per individual is the lesser of participant’s compensation or $53,000 ($59,000 for those eligible to make catch-up salary deferrals). Typically, when a SIMPLE IRA is replaced with a 401(k) profit sharing plan, business owners’ deductible contribution potential and tax savings double by most conservative estimate.
If the $53,000 contribution is not enough, a business sponsoring a 401(k) can add an additional layer, a cash balance plan. Depending on age and income, this approach may unlock contribution potential in excess of $100,000, a level unattainable in a SIMPLE.
Withdrawal Rules SIMPLE IRAs are not a particularly effective employee retention tool. For example, SIMPLEs don’t have a vesting provision or may not require that an individual be employed for the entire plan year to receive a contribution. Vesting rules allow the plan to recapture non-vested balances of participants who separate from service before working a requisite number of years, typically six for match and profit sharing contributions.
SIMPLE accounts do not impose restrictions on when a participant may take a distribution. Account balances may be accessed at any time, for any reason, although the taxes and penalties may be significant. For these reasons, SIMPLEs may not be the best tool to help the business in recouping some of the hidden costs associated with employee turnover.
Accessibility Rules SIMPLE IRAs offer a limited short-term access to savings by way of an indirect rollover. Through an indirect rollover, a participant can access the SIMPLE IRA account value without tax consequences, provided that the amount is redeposited within 60 calendar days from receipt. The new one-per-year per individual limit applies to this transaction.
SIMPLE balances may be accessed at any time, for any reason. No distribution triggering events are required. However, when taken before age 59 ½, distributions are subject to a 10% penalty in addition to ordinary income taxes; the penalty increases to 25% if account is accessed within two years from the first deposit.
Non-IRA plans may offer an important accessibility feature – a loan up to the lesser of 50% of vested account balance or $50,000. Loans are not taxed as long as they are repaid within 5 years with interest, and payments occur at least quarterly. Longer term is available for home purchases.
Taxation Rules Another important consideration is tax management. All contributions made to a SIMPLE plan are pre-tax which means that every dollar deposited into the account along with earnings will be subject to taxation upon withdrawal.
401(k) plans offer a choice between traditional (pre-tax contributions) which grow tax-deferred and are subject to income tax at withdrawal, or Roth 401(k) made with after-tax dollars with tax-free growth and distributions. Plan participants decide whether to make all contributions on a traditional or Roth basis, or combine them as necessary.
Having a tax-free bucket of money in retirement in addition to pre-tax accumulation and savings subject to capital gains treatment expands the options to manage tax liabilities in retirement. Ability to make additional after-tax contributions and convert them immediately inside the plan to Roth, possible in a 401(k) plan, is another reason to reconsider the SIMPLE choice.
How We Can Help Whether it’s a contribution limit, exclusive plan rule, liquidity constraints, lack of tax diversification, or ineffectiveness for employee retention purposes, the SIMPLE IRA may fall short of meeting small business owner needs. We will gladly prepare a side-by-side analysis of the available options which will review tax benefits and costs of annual maintenance so you can help your clients and prospects make an educated decision. SIMPLEs operate on the calendar year, which means that fall is the perfect time to review this analysis prior to the November 2 deadline. The discovery process usually takes less than an hour, however the results can last a lifetime.
Retirement Services is available to consult with you concerning these and other retirement topics. The rules are complex and to succeed you need to either become an expert or align yourself with the right partner. We are available to be an extension of your team. Call us at (888) 926-0600 or click here to connect online.
*2015, subject to COLA increases. **Chart assumptions: 50-year old individual, earning $265,000 per year, 40% effective tax rate.