The full name of these plans is "Savings Incentive Match Plan for Employees" (hence SIMPLE). These plans permit small firms to adopt pension and retirement plans with less paperwork and administration than that required by some of the plans (e.g. most 401(k) plans) adopted by large employers. The plans are funded both by the employees and the employers. The employees voluntarily reduce their wages by a certain amount with this reduction going into their SIMPLE retirement account. The employers also make either matching or nonelective contributions to the employees account; the difference between "matching" and "nonelective" contributions will be explained below. Let's explore first whether the employer qualifies for the SIMPLE, then let's look at the plan in terms of what the employees may contribute to it and then finally let's return to the employer and talk about the employer's contribution.
Here's a tabulation of whether the employer qualifies.
| NO OTHER EMPLOYER-SPONSORED RETIREMENT PLAN | OTHER EMPLOYER-SPONSORED RETIREMENT PLAN | |
|---|---|---|
| MORE THAN 100 EMPLOYEES | employer does not qualify for a SIMPLE | |
| 100 OR FEWER EMPLOYEES | employer qualifies | dubious |
Suppose the employer has 98 employees earning more than $5,000 per year and another ten part-timeers earning less. This employer qualifies for a SIMPLE but should bear in mind that it may pass the 100 threshold in the near future and cease to qualify. Eligible employers who establish and maintain a SIMPLE plan for at least one year, but then fail to qualify (e.g. because they get more than 100 employees) continue to be treated as eligible employers for the two years following the last one in which they did qualify. In making its plans, however, such an employer should bear in mind that it may have to drop the SIMPLE at a later date. Possibly some other type of plan might be more appropriate.
In administering the plan the employer may, at its option, include employees who earn less than $5,000 annually in the plan. Thus the above employer with 98 employees earning more than $5,000 annually and another ten part-timers could qualify for a SIMPLE and could cover all 108 employees. But a SIMPLE plan should indeed be "simple" and covering the ten part-timers raises unnecessary complications.
As a general rule, SIMPLEs are available to an employer only if it sponsors no other retirement plan. Thus an employer that had, say, a defined benefit pension plan would, as a general rule, not qualify to adopt a SIMPLE in addition to the defined benefit plan. There is an exception to this limitation with regard to collectively-bargained retirement plans. If the sponsor maintains another plan - say a 401(k) plan - pursuant to a collectively--bargained agreement, then the employer still qualifies for a SIMPLE. Once again, however, a SIMPLE should be "simple" and, if the employer has a collectively bargained plan, it might be wise to extend the coverage of that plan to all employees rather than having a separate SIMPLE plan for the employees not covered by the collectively-bargained plan.
SIMPLE plans take two forms:
The discussion here is limited to the IRA version of SIMPLEs. These have a number of features that make them particularly useful for small employers. Since the 401(k) version of SIMPLEs involve more paperwork and more complexity, it is probably not as useful for the typical small entity and will not be pursued further here.
ELIGIBLE EMPLOYEES. Given that the employer has established a SIMPLE IRA, an employee must be eligible to participate if he/she earned $5,000 or more of compensation from the employer in each of the two prior calendar years and is reasonably expected to earn $5,000 in the current calendar year. (Nonresident aliens and employees covered by a collective bargaining agreement may be excluded.)
CONTRIBUTIONS. Contributions to the plan come from two sources, the employee and the employer. Given that the employee is eligible, he/she must be permitted to have the employer reduce his/her compensation by up to $10,000 per year (the 2005 limit) with the reduction going into the SIMPLE IRA. (This $10,000 limit goes up year by year, partly from Congressional whim and partly because it will be indexed for inflation.) During the 60 days before the beginning of any calendar year, participants have the right to elect to continue to participate in the plan for that calendar year and to modify the amount of their elective contributions. Employees can terminate their participation at any time during the calendar year but the employer may prohibit re-entry until the beginning of the following calendar year.
Employees older than 50, may increase their elective contribution by $2,000 in 2005 and by $2,500 for later years. Thus an employee over 50 by the end of 2005 could contribute $10,000 "regular" contribution and a "catch-up" contribution of $2,000, for a total of $12,000.)
Smallco, with only five employees, has adopted a SIMPLE. Here's the salary and contributions made by these employees into the SIMPLE IRA.
| SALARY | MAXIMUM CONTRIBUTION | EMPLOYEE CONTRIBUTION | |
|---|---|---|---|
| TONI | $150,000 | $10,000 | $10,000 |
| SAM | $90,000 | $10,000 | 0 |
| PAT | $60,000 | $10,000 | $2,000 |
| JANE | $40,000 | $10,000 | $3,000 |
| MAC | $4,000 | $4,000 | 0 |
Toni didn't have to include Mac in the plan because he earns less than $5,000. She wanted him to have the same opportunity to contribute as the others, however, and told him he was welcome to contribute to the plan. Not surprisingly, bearing in mind his meager salary, Mac wanted no part of that salary to go into an IRA account and wanted all of it to go into his belly.
The total salary of each employee, the total salary that is before the salary reduction contributed to the IRA, is subject to both FICA and Medicare tax. Thus Pat will pay FICA and Medicare tax on her full $60,000 salary. For income tax withholding, however, Pat's salary is only $58,000 and on her personal tax return only the $58,000 will appear. The $2,000 she contributes to her IRA reduces her salary of $60,000 to $58,000 for current tax purposes. Likewise, Jane will pay FICA and Medicare tax on $40,000 but for income tax withholding her salary will be considered to be only $37,000. The employer will, of course, have to match the FICA and Medicare tax paid by the employees.
All contributions to the IRA, whether from the employee as detailed above or from the employer as detailed below, vest immediately. They belong to the employee and are not lost if the employee leaves the company shortly after the contributions are made.
Employees should not, however, think of the accumulation in the IRA account as being available for expenditure in the near future. Distributions from the IRA before age 59.5 will generally be subject to a ten percent early withdrawal penalty and if the distribution is within the first two years of participation in the IRA the penalty may be 25 percent. Yes, in the event of certain emergencies, participants may be able to get at their accumulation without these penalties but participants should think of the amount going in as not being available until they retire. Remember Oscar Wild's bon mot that we should save so that when we are old we can afford the things that only the young can enjoy.
While SIMPLE IRAs are funded in part by the employees, the employer must also make contributions. There is some flexibility with regard to such employer contributions. Thus the employer may make either "matching" contributions each year or may make "non-elective" contributions each year and may switch back and forth between these each year.
MATCHING CONTRIBUTIONS. Employers who choose to make "matching" contributions, match their employees salary "reductions" dollar for dollar up to three percent of the employees compensation each year, again not to exceed $10,000. If this was Smallco's choice, the amounts going into the employee IRAs would be as detailed in this tabulation:
| EMPLOYEE CONTRIBUTION | EMPLOYER CONTRIBUTION | TOTAL IRA CONTRIBUTION | |
|---|---|---|---|
| TONI | $10,000 | $4,500 | $14,500 |
| PAT | $2,000 | $1,800 | $3,800 |
| JANE | $3,000 | $1,200 | $4,200 |
| TOTALS | $15,000 | $7,500 | $22,500 |
Why isn't the "matching" contribution for Toni $10,000? The employer's $4,500 doesn't match her contribution of $10,000. That's because the employer's contribution is limited to three percent of her salary and three percent of her salary of $150,000 is only $4,500. Similarly, Pat only earns $60,000 and accordingly the employer can only match up to $1,800 of what she puts in the plan. If her salary had been $70,000 then the employer could have matched her full $2,000. (But no, the employer couldn't have put in $2,100 because the employer cannot go above matching.)
The employer's matching contributions - $7,500 in the above example - are deductible expenses for the employer but are not income to the employees.
Must the employer continue to make matching contributions of three percent to the plan every year once it adopts a SIMPLE? Not really. There are several ways in which the employer can get out of making these contributions. For one thing, the employer can always discontinue its SIMPLE. No law says that an employer, once having adopted a SIMPLE, must continue to make a SIMPLE available to its employees indefinitely into the future. Bear in mind, however, that a SIMPLE gives the employees a powerful means of accumulating on a tax-free basis substantial savings for their retirement years and employees will not like it when the employer announces that it has opted out of the SIMPLE. Like all details of a SIMPLE, employees have to be informed of the plan and any changes in it so that they can make their arrangements and decide on the amount of their contributions to the plan. The employer will normally tell the employees how the plan works and, if there are any changes in the plan, will tell the employees of these changes well before the beginning of the calendar year so that they can plan accordingly. If the employer tells the employees that the SIMPLE has been dropped, there is likely to be a chorus of groans.
The employer may reduce the three percent matching contribution also; again this is something which should be communicated to the employees well before the beginning of the calendar year. The employer can reduce the matching contribution to as little as one percent of the employee's compensation for any two years in a five-year period. If, in the above example, we were dealing with a one percent matching contribution, the employer's contribution would be only $2,500 not the $7,500 in the tabulation. The employee's tax-deferred IRA accounts would still increase by the $15,000 that they elected to "reduce" their salaries and by the $2,500 matching contribution of the employer. Altogether they have been enriched by $17,500 without paying tax and the $17,500 will grow for many years tax free. The total accumulation will, of course, be subject to tax many years later when they take the money out of their IRA but the SIMPLE nevertheless represents a very valuable wealth accumulation opportunity for the employee even if the employer reduces its maximum contribution to one percent.
There is another way in which the employer can alter its contribution to the plan and in some cases this will reduce the employer's expense. Employer contributions fall into two categories: "matching" and "nonelective." The discussion so far has been in terms of matching contributions. The employer may instead make what are known as "nonelective" contributions. These "nonelective" contributions are two percent of each eligible employee's compensation and they do not "match" employee contributions and they must be made even if the employee makes no contribution out of his/her salary to the IRA. The employees' and employer's contributions to the IRA would, assuming nonelective contributions, be as shown in this tabulation.
| SALARY | EMPLOYEE CONTRIBUTION | EMPLOYER CONTRIBUTION | |
|---|---|---|---|
| TONI | $150,000 | $10,000 | $3,000 |
| SAM | $90,000 | 0 | $1,800 |
| PAT | $60,000 | $2,000 | $1,200 |
| JANE | $40,000 | $3,000 | $800 |
| MAC | $4,000 | 0 | $80 |
| TOTALS | $344,000 | $15,000 | $6,880 |
(Parenthetically, note that the nonelective contribution does not apply to the top dollars of the salary of a highly compensated employee. Jorge played basketball for $5 million in 2004 but the nonelective contribution for 2004 would be limited to $4,100, or two percent of the first $205,000 of 2004 salary. This $205,000 is an "indexed" number.)
Observe also in our previous example that the employer has made a contribution of $80 to an IRA on behalf of Mac. This contribution was not, however, required as Mac, earning less than $5,000, was not an "eligible" employee and did not have to be included in the SIMPLE. From the employer's point of view, his inclusion and the $80 are probably not a good idea. The $80 cannot be a big consideration to Mac even given that it may grow to more than $1,000 by the time he retires. The record-keeping, both for Smallco and for Mac, is a nuisance. Even more important, there are perils in departing in any way from the pattern and prescription for a SIMPLE.
SIMPLEs should be kept "simple." The employer that adopts a SIMPLE is giving its employees a valuable tool to reduce their current income tax and to build on a tax-deferred basis a substantial estate. Employers should not, however, underestimate the paperwork and cost involved in setting up and maintaining a SIMPLE. Employers will normally set these up through financial institutions such as mutual funds, savings and loans, etc. There is paperwork when the plan is begun and there is paperwork and there are administrative details to be taken care of every year by way of notifying employees how it will work for the forthcoming year and in figuring the net pay and contributions to be sent to the funding agency, etc. The world is much too complex for the typical small business. As retirement plans go, the SIMPLE is better adapted for the small business but, SIMPLE or not, it is another complexity to introduce into the business equation. Now return to the complete table of contents for this site.