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Tutorial: SIMPLE IRA Contribution Rules

An explanation of the Contribution rules that apply to a SIMPLE IRA plan.
 
SIMPLE IRA Contribution Rules
 
There are two categories of contributions that can be made to an employee’s SIMPLE IRA.
  1. Employee salary deferral contributions and
  2. Employer contributions
 
Employee Contributions
 
Eligible employees are allowed to make salary deferral (elective deferral) contributions to their SIMPLE IRAs of up to 100% of their compensation, providing the contribution does not exceed the statutory limit of $11,500. If the plan permits, eligible employees who are at least age 50 by the end of the year can contribute an additional $2,500 as catch-up contributions, bringing the total to $14,000.
 
Trivia :Salary federal contributions are amounts an employee elects to have taken from his paycheck and deposited to his SIMPLE IRA ( or other salary deferral featured plans such as a 401(k) or 403(b)) , instead of being paid to him. For SIMPLE IRAs, salary deferral contributions are made on a pre-tax basis, and thus-reduces the employee’s taxable compensation.
 

The employee’s salary deferral election contribution can be expressed as a dollar amount or as a percentage of compensation. Generally, the employer provides the employee with a salary deferral election form, which the employee is required to complete and return to the employer if he wants to make salary deferral contributions to the SIMPLE IRA Plan. The following is a sample of a salary deferral election section of a salary deferral election form.

 

 The employer cannot place a limit on the amount of the employee’s salary deferral contribution, unless that limit is to ensure the contributions do not exceed the statutory limit.  

 
Tax Treatment of Salary Deferral Contributions
 
Taxable Income Reduction
Salary deferral contributions reduce the amount of compensation that is included in the employee’s taxable income.
 
Example:
Tasheca’s W-2 wages for 2009 is $50,000. She elects to defer $10,500 to her SIMPLE IRA. Her taxable income for the year will be $39,500.
Tasheca will not be taxed on the $10,500 until she distributes (withdraws) the amount from her SIMPLE IRA or other plan to which she transfers or rollovers the amount. Accordingly, when her employer calculates the amount of taxes that should be withheld from her salary (paycheck), the amount she contributes as salary deferral should not be included in the salary amount on which the withholding tax is based. In the example above, her employer would compute her withholding tax on $39,500.
 
 
FICA and FUTA
Salary deferral contributions to a SIMPLE IRA are subject to tax under the Federal Insurance Contributions Act (“FICA”), the Federal Unemployment Tax Act (“FUTA”), and the Railroad Retirement Act (“RRTA”). As such, when computing the FICA and FUTA for an employee, salary deferral contributions must be included in the amount of compensation on which the calculation is based. In the example above, her employer would compute her FICA and FUTA on $50,000.
 
 
Employee Participates in Multiple Plans
If an employee works for more than one employer and participates in retirement plans sponsored by each employer, his aggregate salary deferral contributions are limited to what is referred to as the 402(g) limit for the year, plus catch-up contributions. 402(g) is the section of the Internal Revenue Code that governs salary deferral contribution limits.  Under 402(g), an individual’s salary deferral limit for 2009 is $16,500. In addition, an individual’s catch-up contribution limit is $5,500. Let’s take a look at an example:
 
Example: Dawn works as a teacher and participates in the 403(b) plan for her school district. She also works part-time for a pizza parlor and participates in the parlor’s SIMPLE IRA plan. Dawn’s total salary deferral contributions to both plans cannot exceed $16,500, which is the salary deferral limit for the year. She can split the $16,500 between both plans in any way she wants, as long as no more than $11,500 is contributed to the SIMPLE IRA.
 
If Dawn is at least age 50 by the end of the year, she can make catch-up contributions to the plans if the plans permit catch-up contributions. Her aggregate catch-up contributions cannot exceed $5,500. This can be split between both plans, providing the catch-up contribution to the SIMPLE IRA does not exceed $2,500[1].
 
Exception Applies to Deferred Compensation Plans (457 Plans)
Contributions to 457 plans are not treated as alary deferral contributions for purposes of the 402(g) limit. As such, if an employee participates in a 457 plan and a SIMPLE IRA for the same year, the employee may defer up to $16,500 plus catch-up (if eligible) to the 457 plan, and still contribution up to $11,500 , plus catch up to the SIMPLE IRA.
 
Employee Responsibility for Meeting Deferral Limits
If an employee makes salary deferral contributions to more than one retirement plan, he (and hot his employer) is responsible for ensuring that his aggregate salary deferral contributions do not exceed the statutory limit. If his contributions exceed the statutory limit, should notify the administrator for the plan to which the excess contribution was made and make arrangements to have the excess contributions corrected.
 
Salary deferral contributions are made at the employee’s discretion, that is, an employee cannot be forced to make salary deferral contributions to the plan. If the employee decides that he no longer wants to make salary deferral contributions to the plan, he may discontinue his contributions at any time during the year.
 
 
Employer Contributions
Unlike SEP IRAs where contributions are discretionary, employer contributions to SIMPLE IRAs are mandatory. This is important to note for employers who do not want to commit to making contributions every year. On the plus side, the required contribution amounts are capped at only 3% of an employee’s compensation and may not be costly for an employer with a small number of employees, especially if the employees’ compensation amounts are low.
 
Two Options for Employer Contributions
An employer can choose between two options for making contributions to the SIMPLE IRA Plan. These are matching contributions and nonelective contributions.
 
A matching contribution is one that is contingent upon salary deferral contributions made by an employee. For instance, the employer would say, for every $1 you put into your SIMPLE IRA from your paycheck, I will give you $x as a contribution to your SIMPLE IRA. This $x would be a matching contribution.
 
A nonelective contribution is one that is made regardless of whether the employee makes a salary deferral contribution. The employer would say, I will give you $x as a contribution to your SIMPLE IRA, whether or not you make a salary deferral contribution to your SIMPLE IRA.
 
1.    Matching Contributions:
An employer that chooses the matching contribution option is required to make a matching contribution of $1-for-$1, up to 3% of compensation for each employee that makes salary deferral contributions. This 3% can be reduced to no less than 1% for two of every five years, allowing some break for an employer who may find it difficult to meet the 3% requirement.
 
Unlike most other contributions to employer sponsored retirement plans, the 3% matching contribution is not subject to the Compensation Cap. Let’s take a look at some examples of how the 3% matching contribution works.
 
Company Y Inc. adopted a SIMPLE IRA plan and elected to make a 3% matching contribution to the SIMPLE IRAs of employees. The company has four employees who receive the following amounts in W-2 wages. The chart also shows the amount of salary deferral contributions made by each employee.
 

Employee
W-2 Wages
Salary deferral amount
Mary
$350,000
$10,500
Sue
$47,000
$10,500
Tom
$75,000
$5,000

Each employee should receive the following matching contribution amounts
 

Employee
Matching contribution amount
Explanation and computation
Mary
$10,500
Mary receives a $1 for every $1 that she contributes to the plan. While 3% of her compensation is $11,100, she cannot receive a matching contribution of more than she puts into her account. Therefore, the most her employer can contribute to her account is $10,500
Sue
$1,410
Sue receives a $1 for every $1 that she contributes to the plan, up to 3% of her compensation. Even though she contributed $10,500 to her account, her employer cannot contribute more than 3% of her W-2 wages to her account, which is $1,410
Tom
$2,250
Tom receives a $1 for every $1 that he contributes to the plan, up to 3% of his compensation. Even though he contributed $5,000 to his account, his employer cannot contribute more than 3% of his W-2 wages to her account, which is $2,250

 
 
Note: contributions are based on the employees’ total compensation; not their compensation reduced by their salary deferral contributions.
 
Reducing the Matching Contribution
As noted earlier, the employer can reduce the matching contribution to no less than 1% for two of every five years. This five year period includes and ends with the year that the reduction in contributions is made. In addition, the employer may count the following years as part of the five year period for which a 3% matching contribution was made:
  • Any year before the employer (or a predecessor employer) maintained a SIMPLE IRA Plan
  • Any year that the employer made a 2% nonelective contribution (see below) to the plan.
 
Example:
Company Y wants to maintain a SIMPLE IRA for 2008, but can only afford to make a matching contribution of 1%. Since 2008 is the year the SIMPLE was first established, Employer Y is allowed to make the 1% contribution for 2008 because that first year can be counted as year# 5 of the five-year period.
 
The employer must provide notification to employees that the contribution will be reduced for the year. This notification must be provided within a reasonable period before the 60-day election period during which an employee can enter into a salary reduction agreement for the SIMPLE IRA Plan. See Notice Requirements for details on the 60-day election period.
 
Substituting the 2% Nonelective for the 3% Matching Contribution
If an employer elects to make matching contributions to the SIMPLE IRA Plan, and chooses to substitute the matching contribution with a 2% nonelective contribution for any year, the employer must satisfy the following requirements:
  1. Provide notification to employees who are eligible to participate in the plan. The notification must include a statement to the effect that 2-percent nonelective contribution will be made instead of a matching contribution; and
  2. Provide the notification within a reasonable period of time before the 60-day election period during which employees can enter into salary reduction agreements. See Notice Requirements for details on the 60-day election period.
 
The following are some example of when an employer may reduce the 3% matching contribution to an amount that is no less than 1%.
 

Plan Years
Contributions
Comments
1.    2008
1% matching
§ This is OK, because the 2% nonelective contribution is treated as satisfying a 3% requirement, which means the reduction occurred only for 2008 and 2012
2.    2009
2% nonelective
3.    2010
3% matching
4.    2011
3% matching
5.    2012
1% matching
 
1.    2005
1% matching
§ This is OK, because 2% nonelective contribution is treated as satisfying a 3% requirement, which means the reduction occurred only for 2005.
§ The employer may make a reduced contribution of not less than 1% in 2010, as no reduction occurred in the preceding four years.
2.    2006
3% matching
3.    2007
3% matching
4.    2008
3% matching
5.    2009
2% nonelective
 
1.    2006
1% matching
§ This is OK, because 2% nonelective contribution is treated as satisfying a 3% requirement, which means the reduction occurred only for 2006 and 2009.
§ The employer may make a reduced contribution of not less than 1% in 2013, as only one other reduction occurred in the preceding four years.
2.    2007
3% matching
3.    2008
3% matching
4.    2009
1% matching
5.    2010
2% nonelective

 
2.    Nonelective Contribution:
An employer that chooses to make a nonelective contribution must make the contribution to the SIMPLE IRA of every eligible employee, regardless of whether the employee makes salary deferral contributions to the plan.
           
Unlike matching contributions, nonelective contributions are subject to the compensation cap. For instance, if we look at Mary (see above) who earned $350,000 for the year and made a salary deferral contribution of $10,500. Whereas she would receive matching contribution of $10,500, if the employer made a nonelective contribution instead, she would receive only $4,600 in employer contributions. This is because the employer is required to calculate her contribution on no more than $245,000, which is the compensation cap for 2009. ($245,000 x 2%= $4,900).
 
Trivia: An employee cannot refuse to receive employer contributions to his SIMPLE IRA. Why is this even being mentioned? Some employees may not want to receive employer contributions for varying reasons, including the fact that the contribution may affect their eligibility for claiming a deduction for a contribution to a traditional IRA.
 
Making the Choice Between Contribution Types
Affordability of making contributions is often an issue for small business owners. And with SIMPLE IRAs, the question often is: “Which of the two contributions, matching or nonelective, would be more costly?” The answer depends on several factors, which include the following:
 
  • How many employees are eligible to participate in the plan? This will determine the number of employees on whose behalf the employer may need to make contributions
  • How likely is it that employees will make salary deferral contributions? And for those who make salary deferral contributions, how much would they contribute? This would determine the amount of matching contributions that would be required. The answer to the second part of this question may be difficult to determine as no one can know for sure whether the employees will elect to defer zero percent, or 100% up to the maximum dollar amount. But, to err on the side of caution, the employer should plan for the maximum. Of course, if the SIMPLE IRA plan has been in existence for a few years, the employees’ salary deferral trend can be examined and used to make a reasonable projection for future years.
  • Would it be more costly to make matching contributions only to eligible employees who make salary deferral contributions, or make a 2% nonelective contribution to all eligible employees? This too would be hard to determine, unless the plan has been in existence for a few years and a reasonable assumption can be made about how much employees will contribution in future years.
 
An employer can hedge bets by starting with the matching contributions option, reducing it to at least 1% for two of five years, and replace it with the nonelective contributions in some years.
 
Compensation on Which Contributions are Based
Generally, contributions to SIMPLE IRAs are based on the amount of W-2 wages received by the employee. If the employee receives tips and other compensation that is subject to income tax withholding, those amounts are added to the amount of compensation on which contributions are based.
 
Compensation is not reduced by salary deferral contributions. For instance, if an employee receives compensation of $100,000 and makes a salary deferral contribution of $10,000 to a SIMPLE IRA or other retirement plan, the SIMPLE contributions must be based on $100,000 and not $90,000.
 
Salary deferral contributions cannot be based on compensation received before the participant completed the election agreement for making the salary deferral contributions. For instance, if an employee makes his salary deferral election on October 1, only salary that the employee received or earned as of that date is eligible for purposes of making salary deferral election contributions.
 
For a self-employed individual that operates an unincorporated business, contributions are based on net earnings from self-employment, prior to subtracting any contributions made under the SIMPLE IRA Plan on behalf of the individual. That is line-4 Section A, or line-6 Section B of Schedule SE Form 1040, before subtracting any contributions made to the SIMPLE IRA for of the individual. The self-employed individual’s net earnings must be reduced by any matching or nonelective contributions made on behalf of other (non-owner) employees.
 
Example:
 
 
J-Mc adopts a SIMPLE IRA for his sole proprietorship. His net earnings from self-employment is $100,000. He decides to make a matching contribution of 3% to the SIMPLE for the year. In addition, he makes salary deferral contribution of $10,500. His matching contribution is computed as follows:
$100,000 x .9235 = $92,350
$92,350 x 3% = $2,770.5
 
His total contribution would be $10,500 + $2,770.5 = $13, 270.5
 
If he had elected to make a 2 % nonelective contribution to the plan, the employer contribution amount would be $1,847 ($92,350 x 2%).
 
           
 
No Age Limitation on Contributions
Unlike contributions to traditional IRAs, there is no age limitation on contributions that are made to SIMPLE IRAs. An employee who satisfies the service and compensation requirements must be allowed to participate in the SIMPLE IRA Plan by making salary deferral contributions and employer contributions- where required- must be made to his account. However, the required minimum distribution (RMD) rules do apply to SIMPLE IRAs. Therefore, an employee who is at least age 70 ½ must make withdraw RMD amounts from his SIMPLE IRA each year regardless of whether he is still receiving contributions to his SIMPLE IRA.
 
Tax-Deferment on Contributions
Contributions to SIMPLE IRAs are not included in the employees’ income. Instead, the amounts remain tax-deferred in the SIMPLE IRA until withdrawn from the account. Earnings on the contributions accrue on a tax-deferred basis and are also only taxed when withdrawn from the SIMPLE IRA.
See the section on Distributions for information about the tax treatment of distributions from SIMPLE IRAs.
 
Deadline for Making Contributions
SIMPLE IRA contributions must be delivered to the financial institution by the applicable deadline. These are as follows:
 
Salary-deferral Contributions: These must be deposited with the financial institution no later than 30-days after the end of the month to which the deferral applies. For instance, if the employee makes a salary deferral contribution from his paycheck for March, the amount must be delivered to the financial institution no later than 30-days after March 31.
 
According to The Department of Labor, most SIMPLE IRA Plans are also subject to Title I of ERISA, and under Department of Labor regulations[1], SIMPLE IRA salary deferral contributions must be made to the SIMPLE IRA as of the earliest date on which the contributions can reasonably be segregated from the employer’s general assets, but in no event later than the 30-day deadline described above.
 
Employer Contributions: Employer matching and nonelective contributions must be made to the financial institution no later than the employer’s tax filing deadline, including extensions.        

Cash Requirement
SIMPLE IRA salary deferral and employer matching and nonelective contributions must be made in cash.
 
Vesting
SIMPLE IRA contributions are always 100% immediately vested[2]. This means that they can be withdrawn by the participant at anytime. Further, the employer cannot place any withdrawal restrictions on the employee’s SIMPLE IRA. This is a feature that should be considered by employers who are considering choosing a SIMPLE IRA plan, especially if they have high employee turnover. If the employer wants employees to ‘earn’ the contributions the employer adds to the plan before they leave the company for another employer, a plan that allows a vesting schedule may be a better choice.
 
Employer Deducting Contributions
The employer may claim a deduction for salary deferral and employer contributions made to the SIMPLE IRA. Amounts in excess of the contribution limits for the year are not deductible, and the employer may owe the IRS an excise penalty of 10% of excess employer contribution amounts[3].
 
Employee Claiming Tax –Credit
Employees who meet certain requirements are eligible to claim a nonrefundable tax-credit for salary deferral contributions made to their SIMPLE IRAs. This is referred to as the saver’s credit. The saver’s credit is claimed by Filing IRS Form 8880 and following the instructions provided on the form. These include instructions on how to indicate the correct amount on Form 1040. Form 8880 must be attached to Form 1040 in order for the IRS to approve the claim
 


[1] 29 CFR 2510.3-102
[2] IRC § 408(p)(3)
[3] IRC § 4972


[1] IRC § 414(v)(2)(B)(i)