IT'S ALL ABOUT MONEY

SIMPLE IRAS AND EXCESS CONTRIBUTIONS

Part I

By Gary Lesser, JD, and William Clemmer

This article begins a three-part discussion on SIMPLE IRAs and excess contributions. Part I will cover the definition of a SIMPLE plan, establishment, exclusive plan requirement, plans maintained for union employees, acquisition grace period, controlled groups and leased employees, employee eligibility requirements, maximum age requirements, changing eligibility requirements, participation requirements, participation in another plan of a different employer, elective deferrals and maximum annual elective deferrals.

Prior to 1997, small employers had a choice between adopting a simplified employee pension (SEP) plan, a salary reduction SEP (SARSEP) plan or a qualified plan. Under the Small Business Job Protection Act of 1996, Congress created a new retirement plan for small employers that contains a salary reduction feature that, it is hoped, will be more attractive to small employers than the current options under a SARSEP and traditional 401(k) plan.

The Savings Incentive Match Plan for Employees, or SIMPLE plan, is meant to replace the SARSEP plan for years after 1996. Therefore, an employer may not establish SARSEP plans after December 31, 1996. A SARSEP as of December 31, 1996, may continue to operate and to be amended as necessary or needed and include new employees hired after the end of 1996.

Definition of a SIMPLE

A SIMPLE retirement account in IRA form is defined under Code Section 408(p). A SIMPLE may also be established in the form of a qualified 401(k) plan. This article covers SIMPLE plans in the form of an IRA and more specifically, it covers the topic of excess contribution made by employers and employees.

If an employer establishes a SIMPLE plan, each eligible employee may choose whether to have the employer make payments as contributions under the SIMPLE plan or to receive these payments directly in cash. This type of contribution is called an elective deferral (or a salary reduction contribution). The employer must also make either matching contributions or alternatively, 2% non-elective contributions.

All contributions under an employer's SIMPLE plan must be made directly to the trustee or custodian of the employee's SIMPLE IRA. A SIMPLE IRA must be a separate IRA in which the only contributions that can be made are the employee's elective deferral amounts and the employer's matching or non-elective contributions. Rollovers and transfers from other SIMPLE IRAs [but not from SIMPLE 401(k)s] can also be made to another SIMPLE IRA.

SIMPLE plans must be maintained on a calendar-year basis. For example, employer eligibility to establish a SIMPLE plan, employee eligibility to participate in the plan and all SIMPLE contributions are determined on a calendar-year basis, even if the business tax year is a different 12-month period.

Establishment

An existing employer may establish a SIMPLE plan effective on any date between January 1 and October 1 of a year, provided that the employer (or any preceding employer) did not previously maintain a SIMPLE plan. This requirement does not apply to a new employer that comes into existence after October 1 of the year the SIMPLE plan is established (if the employer establishes the SIMPLE plan as soon as possible after the employer comes into existence). If an employer (or preceding employer) previously maintained a SIMPLE plan, the employer may establish a SIMPLE plan effective only on January 1 of a year.

Eligible employer

Eligible employers include those who employ 100 or fewer employees at any time during the preceding tax year. Those employees must receive at least $5,000 in compensation from the employer for such preceding year.

For purposes of this 100-employee limit, all employees of the employer who are working at any time during the preceding calendar year must be taken into account, regardless of whether such employees are eligible to participate in the plan. Thus, employees who are otherwise excludible (e.g., nonresident aliens, union employees and employees who have not met the plan's eligibility requirements) must be included in determining this 100-employee limit. The only employees who can be excluded are those who earned less than $5,000 in compensation from the employer during the preceding calendar year.

There is a two-year grace period for eligible employers who maintain a SIMPLE plan for at least one year and who subsequently become an ineligible employer. In such circumstances, the employer shall be deemed to be an eligible employer for the two calendar years following the last year the employer was eligible. Therefore, an employer may continue to offer the SIMPLE plan for an additional two years after becoming ineligible (i.e., employer has more than 100 eligible employees).

If the failure to be an eligible employer is due to an acquisition, disposition or similar transaction, similar rules that apply under the coverage rules shall apply. In general, this means that if the employers separately satisfied the rules for being an eligible employer before the acquisition, the two-year grace period explained above would apply after the acquisition.

For SIMPLE IRA plans, eligible employers also include tax-exempt organizations and governmental entities. Therefore, pre-tax contributions can be made to the SIMPLE IRA of employees of tax-exempt employers and governmental entities on the same basis as contributions made employees of other eligible employers.

Exclusive plan requirement

In general, an eligible employer must not maintain any other employer-sponsored plans for the taxable year for which the SIMPLE plan is maintained. An employer maintains another employer-sponsored plan if an allocation of contributions is made (a defined contribution plan) or has an increase in benefits accrued (a defined benefit plan) for any plan year beginning or ending in a calendar year for which the SIMPLE plan is being maintained. For this purpose, an "employer-sponsored plan" is a plan, contract, pension or trust described in Code Section 219(g)(5) and includes a plan qualified under Code Section 401(a); a qualified annuity plan described in Code Section 403(a); an annuity contract described in Code Section 403(b); a plan established for employees of a state or political subdivision or by an agency or instrumentality of any state or political subdivision (other than an eligible deferred compensation plan described in Code Section 457(b)); a simplified employee pension (SEP) described in Code Section 408(k), a trust described in Code Section 501(c)(18) and a SIMPLE IRA plan described in Code Section 408(p). Transfers, rollovers or forfeitures are disregarded, except to the extent that forfeitures replace otherwise required contributions.

One question that this requirement raises is what should an employer do if he/she is currently maintaining a qualified plan, especially a money purchase plan? If the employer wishes to begin a SIMPLE plan, the employer must "freeze" or terminate the existing plan first. If the plan is "frozen," such action must be initiated before the end of the year in order to adopt a SIMPLE plan effective for the following year. Also, since we are assuming that there are employees other than the business owner, ERISA requires that the employees be notified of this event at least 15 days prior to the effective date of such amendment.

Another area of concern is where an employer wants to terminate an existing 401(k) plan in order to adopt a SIMPLE plan in IRA form. The 401(k) regulations preclude an employer from establishing any other plan (other than an ESOP or SEP) for a 12-month period following the date that the 401(k) was terminated.

The recent List of Required Modifications (LRMs) for 401(k) amendments contains a new provision to permit the adoption of a SIMPLE IRA plan in the case of a terminated 401(k) plan. However, a SIMPLE IRA cannot be adopted in the same year that contributions are allocated under the 401(k) plan. Alternatively, the employer might consider amending the existing 401(k) plan into a SIMPLE 401(k).

Plans maintained for union employees

If employees (other than collective bargained employees) are eligible for the SIMPLE plan, then the exclusive plan requirement does not apply to a plan maintained for the collectively bargained employees. Therefore, an employer could maintain another plan exclusively for its union employees and a SIMPLE plan exclusively for its non-union employees. The Technical Corrections Act of 1998 confirmed that employees who are not covered under a collective bargaining agreement (including airline pilots) may participate in a SIMPLE IRA plan established by the employer, even if another plan is maintained for the collective bargained employees. (More on this subject later.)

Acquisition grace period

The Technical Corrections Act of 1998 allows for a uniform grace period during which a SIMPLE IRA may be maintained following an acquisition, disposition or similar transaction that affects the employer's ability to meet the following requirements:

1. The 100-employee count;

2. The exclusive plan requirement; and

3. The coverage rules for participation.

If an employer fails to meet any of the above requirements due to an acquisition, disposition or similar transaction, the SIMPLE IRA may be maintained during a "transitional period." This transitional period begins on the date of the transaction and ends on the last day of the second calendar year following the year in which the transaction occurs.

In order for the grace period to apply, coverage under the plan may not be significantly changed during the transitional period. Moreover, the SIMPLE IRA may not be maintained during the transition period unless it would have met the requirements after the transaction, if the employer maintaining the plan had remained a separate employer.

Example: Candy owns Touch of Class, a hair salon. She adopts a SIMPLE IRA for her company, which has 18 employees. On June 1, 2001, Candy acquires another salon, Hair Today, which has a money purchase plan for its 25 employees. Touch of Class may continue the SIMPLE IRA during the period from June 1, 2001, to December 31, 2003. Coverage under the SIMPLE IRA may not be significantly changed, and only individuals who would have been employees of Touch of Class had the transaction not occurred are eligible to participate.

Controlled groups and leased employees

For purposes of determining whether an employer is eligible to establish a SIMPLE plan, certain related employers (trades or businesses under common control) are treated as a single employer. Related employers include controlled groups of corporations under Code Section 414(b), partnerships and sole proprietorships under common control under Code Section 414(c) and affiliated service groups under Code Section 414(m). In addition, leased employees described in Code Section 414(n) are treated as employed by the employer if such employee meets the following requirements:

1. Services are provided by the leased employee pursuant to an agreement between the recipient employer and any leasing organization;

2. Such person has performed services for the recipient employer on a substantially full-time basis for a period of at least one year; and

3. Such services are performed under the primary direction or control by the recipient employer.

Leased employees are treated as any other employees for plan coverage and participation unless the leasing organization maintains a "safe harbor plan," which is a money purchase pension plan providing full and immediate vesting, immediate eligibility and a contribution of at least 10%. The plan may be integrated, but the base percentage must be at least 10%.

Employee eligibility requirements

All eligible employees of the employer (including employees of a controlled group of employers and certain leased employees) must be permitted to voluntarily elect to have their compensation reduced by an amount determined by the employee. Eligible employees include those who have received $5,000 in compensation from the employer in each year of any two preceding years (whether or not consecutive) and are expected to receive at least $5,000 in compensation for the current year.

An employer would be permitted to establish less restrictive requirements, such as immediate eligibility by eliminating or reducing the prior year compensation requirements, the current year compensation requirement or both. However, the employer cannot impose any other conditions on participating in a SIMPLE plan.

An employer, at its discretion, may exclude any employee described in Code Section 410(b)(3) from eligibility. The document must affirmatively exclude such employees by classification. The following employees may be excluded:

1. An employee who is included in a unit of employees covered by an agreement that the Secretary of Labor finds to be a collective bargaining agreement between employee representatives and one or more employers--if there is evidence that retirement benefits were the subject of good-faith bargaining between such employee representatives and such employer or employers. In general, the mere existence of a collective bargaining agreement will satisfy this requirement.

2. In the case of a trust established or maintained pursuant to an agreement that the Secretary of Labor finds to be a collective bargaining agreement between air pilots represented in accordance with Title II of the Railway Labor Act and one or more employees.

3. An employee who is a nonresident alien and who received no earned income [within the meaning of Code Section 911(d)(2)] from the employer that constitutes income from sources within the United States [within the meaning of Code Section 861(a)(3)].

The employer aggregation rules and leased employee rules apply for purposes of Code Section 408(p). Thus, if two related employers must be aggregated under the rules of Code Section 414(b), then all employees of either employer who satisfy the eligibility criteria must be allowed to participate in the SIMPLE plan.

It should be noted that the IRS model SIMPLE forms automatically exclude from participation nonresident alien employees receiving no earned income from an employer that constitutes income from sources within the United States, but allow an employer to choose whether to exclude employees covered under a collective bargaining agreement for which retirement benefits were the subject of good-faith bargaining.

Maximum age requirements

There is no age or years of service requirement. An employee will not fail to be eligible to participate merely because he/she has attained age 70 1/2.

Changing eligibility requirements

An employer cannot change eligibility requirements during the same year. Once the employees are notified of the employer's eligibility requirements for a plan year, those elections cannot be changed until the employer gives notice of the change effective for the next plan year. An employer could not, for example, permit immediate eligibility for all employees who are employed when the plan is adopted but then require all new employees to meet other requirements to be eligible during that same plan year. On the other hand, eligibility requirements may be changed, provided the amendment is consistent with the prior notification.

Participation requirements

A SIMPLE will satisfy the participation requirements if all employees who meet the eligibility requirements outlined above are eligible either to make a salary reduction election or to receive the employer's non-elective contribution.

Participation in another plan of a different employer

An employee may participate in a SIMPLE established by an employer even if he/she also participates in a plan of a different employer for the same year. However, the employee's aggregate salary reduction contributions under all plans are subject to the overall deferral limits of Code Section 402(g), which is currently $10,500 [or an aggregate of $8,000 in the case of an eligible state deferred compensation plan under Code Section 457(b)].

If an employee works for two unrelated employers who both have SIMPLE plans, the employee's aggregate elective contributions between the two plans would be $10,500. An employer who establishes a SIMPLE plan is not responsible for monitoring compliance with either of these limitations for employees who may have participated in a plan of an unrelated employer. It is the individual taxpayer's responsibility to monitor the aggregate salary reduction contribution limits per year.

Elective deferrals

An elective deferral or salary reduction contribution is one made pursuant to an employee's election to have an amount contributed to his/her SIMPLE IRA, rather than have the amount paid directly to the employee in cash. An employee must be allowed to choose to have elective deferrals made at the level specified by the employee, expressed as a percentage of compensation for the year or expressed as a specific dollar amount. An employee's elective deferrals must come from future paychecks received after executing a salary reduction agreement, but the total amount of deferrals can be based upon compensation from the employer for the entire calendar year.

An employer may not place any restrictions on the amount of an employee's elective deferrals (such as limiting the percentage of compensation), except to the extent needed to comply with the annual limit on elective deferrals under a SIMPLE plan (described later). In other words, an employee could elect to defer 100% of his/her compensation, subject to the maximum limits that will be discussed later. It should be noted that elective deferrals can be made only from compensation that the employee otherwise would have received in cash. Thus, the maximum amount of gross compensation that can be contributed is reduced for income tax withholding, social security taxes and any other proper deductions or offsets.

Elective deferral contributions can begin with the first payroll period following the day the employee signs a "deferral election form," even if the 60-day election period has not expired for that employee.

Maximum annual elective deferrals

For 2001, the maximum annual elective deferral contribution per employee is $6,000 (unless changed by Congress). This $6,000 deferral limit will be adjusted for cost of living in increments of $500, rounded to the next lowest multiple of $500.

A SIMPLE IRA is not subject to the Code Section 415 limitations on annual additions (the overall 25% of compensation limit or $30,000). This means that an employee could elect to defer up to 100% of compensation not to exceed $6,000. However, an employee's gross compensation would need to be $6,497.02 or greater in order to defer the full $6,000. This is because the employer must collect the employee's portion of FICA taxes (7.65%) from the employee's pay. Therefore, in this example, the FICA tax equals $497.02 (7.65% X $6,497.02), which leaves exactly $6,000 for the employee to contribute as an elective deferral. [The employee would actually need to earn more than $6,497.02 because federal income tax withholding would still be required to be withheld on any compensation not being deferred. State withholding rules must also be considered.]

Elective deferral contributions must come from future paychecks received by the employee following the day the employee signs an elective deferral form. However, the employee's total compensation for the year is used to determine the amount of the employee's elective contribution. For example, an employee earns $10,000 from January 1 to June 30, and $4,000 from July 1 to December 31, but signs an election deferral form on July 1. The employee can defer up to $4,000 because the source of any deferrals for the year must come from the amount earned after June 30. *