8.18 SIMPLE IRA Contributions and Distributions

The only contributions that may be made to a SIMPLE IRA are elective salary-reduction contributions by employees and matching or non-elective contributions by employers. All contributions are fully vested and nonforfeitable when made.

Regardless of compensation, eligible employees (8.17) may elect each year to make salary-reduction contributions to the plan up to the annual SIMPLE IRA limit (8.17). Salary-reduction contributions are excluded from the employee’s taxable pay on Form W-2 and not subject to federal tax withholding. They are subject to FICA withholding for Social Security and Medicare tax.

Eligible employees must be given notice by the employer of their right to elect salary-reduction contributions and at least 60 days to make the election. After the first year of eligibility, the election to defer for the upcoming year is made during the last 60 days (at minimum) of the prior calendar year. If the employer uses model IRS Form 5304-SIMPLE or 5305-SIMPLE, a notification document is included.

If an employee contributes to a SIMPLE IRA and also to a 401(k) plan, 403(b) or salary-reduction SEP of another employer for the same year, the salary-reduction contributions to the SIMPLE IRA count toward the overall annual limit on tax-free salary-reduction deferrals (7.17). Deferrals over the annual limit are taxable and must be removed to avoid being taxed again when distributed from the plan (7.18).

Employer contributions.

Each year, the employer must make either a matching contribution or a fixed “non-elective” contribution. If the employer chooses matching contributions, the employee’s elective salary-reduction contribution generally must be matched, up to a limit of 3% of the employee’s compensation. For up to two years in any five-year period, the 3% matching limit may be reduced to as low as 1% for each eligible employee.

Instead of making either the 3% or reduced (between 1% and 3%) limit matching contribution, the employer may make a “non-elective” contribution equal to 2% of each eligible employee’s compensation. If this option is chosen, the 2% contribution must be made for eligible employees whether or not they elect to make salary-reduction contributions for the year. The 2% contribution is subject to an annual compensation limit, which for 2012 was $250,000. Thus, for 2012, the maximum 2% non-elective contribution was $5,000 (2% of $250,000) even if an employee earned more than $250,000. The 3% matching contribution is not subject to the annual compensation limit, but only to the annual salary-reduction limit (8.17). The employer must notify eligible employees of the type of contribution it will be making for the upcoming year prior to the employees’ 60-day election period for making elective salary-reduction contributions. The employer must make the matching or non-elective contributions by the due date for filing the employer’s tax return (plus extensions) for the year.

Planning Reminder

Employer’s Intended Contributions

The IRS model notification included with Form 5304-SIMPLE or 5305-SIMPLE requires the employer to tell employees how much the employer will be contributing for the upcoming year.

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Distributions from a SIMPLE IRA.

A distribution from a SIMPLE IRA is fully taxable unless a tax-free rollover or trustee-to-trustee transfer is made. The penalty for distributions before age 59½ (8.12) is increased to 25% from 10%, assuming no penalty exception applies, if the distribution is received during the two-year period starting with the employee’s initial participation in the plan. After the first two years, the regular 10% penalty applies.

Caution

Increased Pre–Age 59½ Penalty

In the first two years of SIMPLE IRA participation, the penalty for distributions before age 59½ is increased from 10% to 25%.

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In the initial two-year period, a tax-free rollover or direct trustee-to-trustee transfer (8.10) of a SIMPLE IRA may be made to another SIMPLE IRA. After two years of participation, a tax-free rollover or direct transfer may be made to a traditional IRA, qualified plan, 403(b) plan, or state or local government 457 plan, as well as to a SIMPLE IRA. The mandatory distribution rules that apply to regular IRAs after age 70½ also apply to SIMPLE IRAs (8.13).