SIMPLE IRA: Eligibility requirements, contribution limits, compliance

What is a SIMPLE IRA?

A SIMPLE IRA is a tax-deferred employer-sponsored retirement plan designed to make retirement savings more accessible for small businesses. In 2023, the Secure Act introduced the option for SIMPLE Roth IRA contributions, resulting in tax-free retirement distributions in lieu of tax-advantaged contributions.

Eligibility requirements

For a business to establish a SIMPLE IRA, it must meet the following criteria:

• Have a workforce of no more than 100 employees.
• Each employee must have earned at least $5,000 during any two years prior to the current calendar year and anticipate receiving at least $5,000 during the current calendar year in the previous calendar year.
• Must not have any other retirement plan.

(SIMPLE IRAs are also available to self-employed individuals, including sole proprietors.)

Setting up and managing a SIMPLE IRA plan

Setting up a SIMPLE IRA plan involves choosing a trustworthy financial institution, drafting a plan document, and communicating effectively with employees. 

The selected financial institution acts as the plan’s trustee, managing the funds deposited by the employer. 

Employers have a responsibility to keep track of the performance and fees of the financial institution to ensure the plan is operating effectively and serving the employees’ best interests.

Choosing a financial institution

Banks, insurance companies, and some regulated investment firms are among the eligible financial institutions. They act as a trustee and perform the following tasks:

• Receiving and investing contributions
• Providing the employer with a summary description of the plan
• Providing a statement to employees at the time of first contribution and at least annually thereafter
• Explaining any fees and commissions applied to SIMPLE IRA assets

Establishing the plan

Employers can establish a SIMPLE IRA plan by filling out IRS Form 5304-SIMPLE or Form 5305-SIMPLE, which outline employee eligibility criteria and various contribution options.

The plan can typically be established anytime between January 1st and October 1st, but new businesses starting after October 1st have the flexibility to set up the plan as soon as administratively feasible thereafter.

Employee enrollment and communication

Clear and consistent communication is vital for successfully maintaining a SIMPLE IRA plan. 

Employers must:

• Notify employees about their right to participate in the match plan for employees
• Provide employees with a summary description of the plan
• During the 60-day election period, give employees the opportunity to enter into or modify a salary reduction agreement
• Inform employees of either the matching or nonelective contributions they will receive for the following year.

Simple IRA contribution limits and rules

Overview: SIMPLE IRA contribution limits

• For employees, the maximum contribution limit for 2024 is $16,000.
• For those aged 50 and older, additional catch-up contributions max out at $3,500.
• Employees can terminate their salary reduction contributions at any time, but they may face restrictions on resuming contributions until the next calendar year.
• Employers must make matching or nonelective contributions to their employees’ SIMPLE IRAs as part of the savings incentive match plan.

Employee contributions

For employees, the elective deferral limit for a SIMPLE IRA in 2024 is $16,000, which includes salary deferral contributions. However, if you are 50 or over, you can make additional catch-up contributions of up to $3,500, allowing a total annual contribution max of $19,500. Although lower than those for other retirement plans like 401(k)s, these limits are still significant and can help you build a substantial retirement nest egg.

Employer contributions

Employers must contribute to their employees’ SIMPLE IRA accounts. The contribution can either match employee contributions up to 3% of their compensation or a 2% nonelective contribution for each eligible employee, irrespective of the employee’s contributions.

This ensures that even if an employee chooses not to contribute to their SIMPLE IRA, they still receive contributions from their employer, thereby boosting their retirement savings.

Withdrawals, rollovers, and distributions

Early withdrawal penalties

Early withdrawals from a SIMPLE IRA can incur significant penalties. If you withdraw funds before reaching the age of 59½, not only will you have to pay income tax on the distributed amount, but you will also have to pay an additional 10% tax penalty. Moreover, if you make a withdrawal within the first two years of participation, this additional tax increases to a steep 25%.

However, there are certain exceptions to these penalties, such as withdrawals for:

• certain medical or educational expenses
• first home purchase
• annuity withdrawals
• disability
• beneficiaries receiving a death benefit from a deceased owner
• an IRS levy on income taxes

Rollover rules

Rolling over funds from a SIMPLE IRA to other retirement accounts, such as traditional IRAs, can sometimes be tricky. 

IRS rules state that you must wait two years from your first contribution before rolling over funds into a traditional IRA or another employer plan without tax penalties. Initiating a rollover within the first two years of participation will be considered a taxable event.

Rollovers are tax-free after the two-year waiting period if completed within 60 days of receiving the distribution. However, it’s important to note that rollovers from a SIMPLE IRA to a Roth IRA are treated as taxable conversions.

Required minimum distributions

Another significant factor in SIMPLE IRAs is the required minimum distribution (RMD). According to the SECURE 2.0 Act, those who reach age 72 after December 31st, 2022, must begin taking RMDs from their SIMPLE IRA at age 73. 

The RMD amount is determined by dividing the account balance as of December 31st of the prior year by an IRS life expectancy factor. Failing to meet the RMD can result in a 50% excise tax on the amount not withdrawn. However, the penalty can be waived if the shortfall was due to reasonable error and steps are taken to correct it.

Correcting errors and monitoring compliance

Ongoing compliance is a critical part of managing a SIMPLE IRA plan. Employers should conduct annual self-audits to check for potential errors and verify that the plan operates according to IRS rules and regulations. 

The IRS provides a SIMPLE IRA plan checklist and Fix-It Guide to help employers identify and correct common mistakes. The IRS Employee Plans Compliance Resolution System (EPCRS) is another valuable resource for correcting various plan errors.

Identifying and correcting errors

Employers have an important responsibility in identifying and rectifying errors. For instance, employee contributions must be deposited promptly, no later than 30 days after the end of the month, in which the amounts would otherwise have been payable to the employee. Failure to provide necessary information to employees could incur a $50 penalty for each day the failure continues.

The Voluntary Correction Program (VCP) is another helpful tool to rectify SIMPLE IRA plan errors and ensure affected participants are made whole.

Ensuring plan compliance

Employers should carry out an annual self-audit of their SIMPLE IRA plan to ensure compliance with IRS rules and regulations. This involves reviewing the plan’s operation, checking that all eligible employees are included, and ensuring that employer contributions are made correctly. 

Employers must evaluate the impact of the failure and make a reasonable correction if the annual SIMPLE IRA plan notification requirements were not followed. In addition, the financial institution’s performance and fees should be monitored to ensure proper plan management.

Terminating a SIMPLE IRA plan

In certain situations, terminating a SIMPLE IRA plan might be necessary. This could be due to a business exceeding 100 employees or a change in retirement plan strategy. Whatever the case may be, you must notify your SIMPLE IRA plan’s sponsor and your employees before November 2nd before the effective termination year.

While you are not required to inform the IRS upon plan termination, maintaining a record of the termination decision is recommended.

Pros of SIMPLE IRAs

Employers

• Lower start-up and operating costs than conventional retirement plans
• Tax deductions for contributions made to employees

Employees

• Immediate vesting of all contributions and earnings
• Instant ownership promotes a shared investment in their future retirement security

Cons of SIMPLE IRAs

Employers

• Employers must contribute to their employees’ SIMPLE IRA accounts, possibly reducing flexibility in plan operations
• A plan cannot be terminated or amended mid-year

Employees

• Investment choices may be restricted due to limitations set by the sponsoring firm (mutual funds are most common)

Both

• If a business exceeds 100 employees, it may no longer be eligible to maintain the plan, presenting a possible scalability issue for growing businesses

Final word

A SIMPLE IRA is a retirement plan for small businesses and self-employed individuals. It offers ease of setup, tax advantages, and a shared commitment to retirement savings between employers and employees. However, like any retirement plan, it comes with its own set of rules, regulations, and potential limitations. Understanding these aspects is essential to making the most out of a plan to ensure a secure retirement.

Frequently Asked Questions

How does a SIMPLE IRA work?

A SIMPLE IRA allows employees to set aside a percentage of pay for retirement with guaranteed employer contributions. The account grows tax-deferred until withdrawn in retirement (creating a taxable event).

What are the disadvantages of a SIMPLE IRA?

Some SIMPLE IRA disadvantages include limited contribution limits (compared to other employer-sponsored retirement accounts) and early withdrawal penalties.

What is the SIMPLE IRA 2-year rule?

After two years, you can make tax-free rollovers from SIMPLE IRAs to other types of non-Roth IRAs or employer-sponsored retirement plans, but you must include any untaxed money rolled over in your income.

Is a SIMPLE IRA better than a 401(k)?

Neither plan is better than the other. It will ultimately depend on your specific needs and goals. While SIMPLE IRAs are generally easier to manage than 401(k) plans, their contribution limits are lower, which can affect employees’ retirement savings rates. Employers should consider their administrative capacity and savings goals when choosing between the two.

What are the contribution limits for a SIMPLE IRA plan?

The contribution limit for a SIMPLE IRA plan in 2024 is $16,000 for employees, with an additional catch-up contribution of $3,500 for those aged 50 and over.