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What You Must Know About SIMPLE IRAs

Let’s begin with the most basic question: What is a SIMPLE IRA? The acronym SIMPLE stands for “Savings Incentive Match Plans for Employees of Small Employers.” In short, it’s a salary reduction retirement plan offered by employers that allows workers to contribute pretax earnings to a tax-favored account. While businesses can use SIMPLE IRAs as a tax-saving strategy as well, we’ll focus on the benefits for individuals.

How Do Employees Qualify for a SIMPLE IRA?

As mentioned, a SIMPLE retirement plan allows employees to set aside pretax dollars in retirement accounts that can grow apart from taxation until withdrawals are made in the future. So in this case, a person can qualify for a SIMPLE IRA plan so long as their employer is offering it. If a business is not offering it, the workers can’t take advantage of it. 

Employers who do offer a SIMPLE IRA plan must file a form to set up the employee’s account. At that time, they’ll identify a designated institution where the employee’s contributions and any matching funds will be deposited. The employer can also allow the employee to choose the institution where the funds are deposited. 

Contributions are voluntary, and the individual has ownership of all the money in the SIMPLE IRA. If there are any negatives of this type of plan, they are that loans are not allowed and there are lower contribution limits than with some other retirement plans.

How Much Can I Contribute to a SIMPLE IRA?

The amount of money you can contribute to a SIMPLE IRA from your salary has an inflation-adjusted annual limit. Workers older than 50 can make extra catch-up contributions. Meanwhile, employers must make a contribution, but they can choose how to calculate the amount they give.

Businesses can either match the contribution in an amount between 1% and 3% of the worker’s compensation or make a nonelective contribution of 2% of salary to all employees, regardless of whether the employees contribute. All contributions made to these accounts, including the employer’s contributions, are 100% vested from the start.

What Are the Employer’s Obligations for a SIMPLE IRA?

In addition to the financial contributions, every year, employers must provide employees with an update on the status of the plan. They must deliver this update before the start of the annual election period, which is usually the 60 days before January 1 each year (November 2 to December 31), with a few exceptions. These status updates must include the following: 

  • A description of the employee’s opportunity to make or modify salary reduction changes under the plan
  • Notice of the employer’s plan to make matching or nonelective contributions
  • A summary description of the plan provided by the financial institution
  • Written notice that the employee’s balance can be transferred without cost or penalty if they use a designated financial institution

Any employer who wishes to set up a SIMPLE IRA — whether it be a self-employed individual, tax-exempt organization or government entity — must have no more than 100 employees earning $5,000 or more in compensation during the preceding calendar year.

Does a SIMPLE IRA Conflict with a Traditional 401(k) or a Roth 401(k)?

A person can contribute the maximum allowed amounts to both a Roth IRA and a SIMPLE IRA. This is because their contribution limits are not cumulative. This is why some people max out both their Roth IRA and their SIMPLE IRA. That said, a SIMPLE IRA cannot be a Roth IRA, and vice versa. They are two different plans, but they can complement each other nicely. 

It’s a little uncommon to contribute to both a 401(k) and a SIMPLE IRA in the same year. This is because an employer can only offer either a 401(k) or a SIMPLE IRA, not both. So, a person can only contribute to both if they change employers during the year.

Limitations of Participating in SIMPLE IRAs

There are a few limitations to keep in mind. An employee must earn at least $5,000 in compensation during any two years before the current calendar year and expect to receive at least $5,000 during the current calendar year. Employers can also use less restrictive requirements, such as eliminating or reducing the prior or current year compensation amounts.

If a person only received $3,000 the prior year, for example, they can ask their employer if they’d be willing to lower the $5,000 threshold. However, it is the employer’s decision. They can’t, however, make the minimum over $5,000. 

Employers can also exclude employees covered by a union agreement and whose retirement benefits were bargained for in good faith by the employees’ union and the employer. In addition, employers are not required to include employees in SIMPLE IRA plans who are nonresident aliens with no US wages, salaries or other personal services compensation from the employer.

Can an Employee Stop Contributing to SIMPLE IRA?

Workers can terminate their salary reduction contributions to a SIMPLE IRA any time they wish. If they do so, they may be excluded from resuming contributions for the remainder of the calendar year. Employers that are making nonelective employer contributions must continue to make these contributions on behalf of the employee.

How to Correctly File SIMPLE IRA

There are no filing requirements for the employer. For individuals, SIMPLE IRA contributions are not included in the “Wages, tips, other compensation” box of Form W-2, but check the “Retirement Plan” in box 13:

Salary reduction contributions must be included in the boxes for Social Security and Medicare wages. The good news is that SIMPLE IRA contributions are not subject to federal income tax withholding. Keep in mind that salary reduction contributions are subject to social security, Medicare and federal unemployment taxes. Matching and nonelective contributions are not subject to these taxes.

How to Tax Plan for a SIMPLE IRA

Much like a 401(k) plan, SIMPLE IRAs can be funded with pretax salary reduction. This means a contribution reduces a person’s taxable income. For this reason, there won’t be a deduction on a tax return because it doesn’t appear in a person’s taxable income. That said, sole proprietors may deduct both salary reduction contributions and matching contributions from Form 1040. For further tax planning strategies, check out tax planning software

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