Over the course of the last two weeks, we reviewed the key features of Solo 401(k) and SEP IRA retirement plans for small businesses. Both plans provide small business with a great opportunity to save for retirement. They are very easy to establish with low costs, simple administration, and have generous contribution limits. On top of that, all contributions are discretionary, meaning the employer decides how much to contribute each year depending on their business needs.
However, there are some tradeoffs. For example, Solo 401(k) plans are only available to small businesses with no common-law employees except for the owner and his/her spouse. This requirement essentially limits them to the self-employed. On the other side, weak eligibility requirements for SEP IRAs require employers to even include seasonal and part-time workers in the plan. Of course that can result in rising operating costs.
In this final series of non-qualified retirement plans, we would like to cover one more retirement plan available to small businesses. It is called a Savings Incentive Match Plan for Employees of Small Employers, or more commonly a SIMPLE IRA.
Establishment
Like with Solo 401(k) and SEP IRA plans, establishing a SIMPLE IRA is very easy. All you need to do is adopt a plan document by filling out Form 5304-SIMPLE, Form 5305-SIMPLE, or use a prototype document. The difference between the forms is that Form 5304-SIMPLE allows plan participants to use their preferred financial institution, while in Form 5305-SIMPLE the financial institution is selected by the employer. Neither of the documents must be filed with the IRS.
A SIMPLE IRA can be established between January 1st and October 1st and by all types of businesses. However, businesses that came into existence after October 1st can set up a SIMPLE IRA plan as soon as administratively feasible.
Employers must employ less than 100 employees with a compensation of at least $5,000 during the previous calendar year. If the employer employs more than 100 employees with a compensation of at least $5,000, a two-year grace period is granted during which the employer may continue to fund the plan.
Contribution Limits
Contributions to a SIMPLE IRA can be made by both employer and employee. The employer is required to make either a matching contribution on a dollar-for-dollar basis up to 3% of the employee’s compensation, or a flat (nonelective) 2% contribution for each eligible participant. For nonelective contributions an employee’s compensation of $270,000 (for 2017) is considered.
If an employee decides to make elective salary deferrals, an employer can temporarily reduce the match to below 3% (but no less than 1%) in any two out of 5 plan years.
As with other retirement plans, employer’s contributions are deductible from current taxable income. In addition to that, employee salary deferrals are excluded from personal taxable income.
An employee can contribute up to $12,500 in 2017 (plus an additional $3,000 as a catch-up contribution if older than age 50 by the end of the plan year). For example, John has an annual compensation of $100,000 and made a maximum contribution of $12,500. His employer is required to add an additional 3% of the compensation or $15,500 total.
The employer’s contributions must be made to the designated custodian no later than the due date for filing the employer’s tax return, including extensions for the employer’s tax year for which the contributions were made. Employees’ salary reduction contributions must be deposited to their SIMPLE IRAs within 30 days after the end of the month.
Reporting
Even though employers are not required to file any annual reports with the IRS, there are a few notices employers must provide on a regular basis. Specifically, employers need to notify each eligible employee of:
Contribution method elected by the employer: either matching contribution or nonelective contributions (flat 2%)
His or her right to make a salary reduction contribution under the plan
His or her right to make or change a salary reduction choice before the beginning of the election period
His or her right to transfer the balance without a cost, or penalty, if an employer designated financial institution is used when depositing contributions.
In addition to that, employers must provide eligible employees with a summary plan description then report to the IRS on Form W-2 each participant’s salary reduction.
Distributions
Generally, the same distribution rules apply as to traditional IRAs. All distributions are taxable and includible as ordinary income. Distributions prior to age 59 ½ are subject to a 10% tax penalty. Besides that, a SIMPLE IRA is subject to the required minimum distributions.
However, there is a special two-year rule that applies exclusively to SIMPLE IRAs. If a participant takes a distribution within two years of joining the plan, this distribution is subject to a 25% tax penalty. In addition, all rollovers within this two-year period can only be made to another SIMPLE IRA. The 25% penalty is waived if over the age 59 ½.
Other Features
Employer isn’t responsible for the investment results
Employers are not allowed to have other qualified plans
Employees are immediately and fully vested in employer contributions
More investment flexibility – employees can invest in any exchange traded vehicles, including individual stocks
Conclusion
Despite having many things in common with other non-qualified retirement plans, there are a few things that make a SIMPLE IRA different and less appealing than other plans. In terms of commonalities, a SIMPLE IRA is easy to establish, has low maintenance costs, doesn’t require any special filing with the IRS, and there is no responsibility for investment results. The whole process of maintaining a plan is usually smooth. This makes a SIMPLE IRA a decent option when saving for retirement, for both small business owners and rank-and-file employees.
However, the SIMPLE IRA, despite stricter eligibility rules, lacks one of the important benefits of other non-qualified plans – employer’s discretionary when making contributions. It is no secret, that even a matured small business can still have periods of ups and downs, and having discretion in making contributions in those unfavorable times is a must-have for many business owners. Although, this drawback is partially compensated by having a 3% cap on matching contributions, and allowing employees to make their own elective salary deferrals. Essentially, employees’ participation allows them to share costs with the employers.
When it comes to contribution limits, a SEP IRA is also a laggard. The maximum that can be contributed by an employee is $12,500 plus $3,000 catch-up contribution if older than 50. One good thing an employer can do is add $12,500 on top of it. However, to enjoy this generous “gift”, an employee’s annual compensation must be equal to $416,667 which is far from today’s reality.
It is hard to say whether SIMPLE IRAs are inferior to other non-qualified retirement plans, as there are so many factors that need to be considered. If you are just starting out your business and your cash flow is still not stable, setting up a SIMPLE IRA may not be the best option due to mandatory contributions. A SEP IRA would probably be a better option here. However, if your business is matured with predictable cash flow, and a majority of employees are getting an average pay, the SIMPLE IRA can be a great option for highly compensated employees. It would allow them to maximize their own contributions and avoid all hassle of traditional 401(k) plans.