This final installment of the three-part series on SIMPLE IRAs and excess contributions will address, among other things, employer deductions, nondeductible employer contributions, tax treatment, rollovers and transfers, ERISA implications and other rules, and the treatment of excess elective deferrals. Previous installments appeared in the January and February issues of Rough Notes magazine. You also can access these articles on the Rough Notes Company Web site (www.roughnotes.com).
Establishment of the SIMPLE IRA
If an eligible employee who is entitled to a contribution under a SIMPLE Plan is unwilling or unable to establish a SIMPLE IRA with any financial institution prior to the date on which the contribution is required to be made to the SIMPLE IRA of the employee, an employer may execute the necessary documents to establish a SIMPLE IRA on the employee's behalf with a financial institution selected by the employer.
Employer deduction
Employer contributions under a SIMPLE plan (including the elective deferrals and the matching or non-elective contributions), to the extent that such contributions do not exceed the limits, are deductible by the employer on the tax return filed with or within which the calendar year for which the contributions were made ends.
Remember that a SIMPLE plan must operate on a calendar year basis, even if the employer's business files the company's tax return on another 12-month basis. Therefore, the calendar year must be used to determine the following:
1. Whether the employer is an "eligible employer";
2. Which employees are "eligible employees"; and
3. Compensation in determining deferrals, matching or non-elective contributions.
Example. Hobo, Inc., operates its business on a fiscal year basis, from October 1, 2001, through September 30, 2002. If Hobo adopts a SIMPLE plan for 2001, the calendar year of 2001 is used to determine eligibility and contributions for that year. However, such contributions will be deductible on the federal income tax return (Form 1120) of Hobo filed for the fiscal year ending September 30, 2002.
Nondeductible employer contributions
Code Section 4972 was amended to add SIMPLE plans to the list of plans that can have "nondeductible employer" contributions subject to the 10% excise tax. Therefore, if the employer contributes more than the deductible amount, the employer is liable for a tax equal to 10% of the nondeductible contribution and must file Form 5330 with the IRS. There is presently no guidance on what happens if the employer has a nondeductible employer contribution (i.e., contributes more than the 3% match or 2% non-elective) or its effects on the employee's SIMPLE IRA. Therefore, an employer might wish to wait until it is absolutely certain of the correct deductible amount of the contribution. In the alternative, an employer might limit its contribution to the percentage it has agreed to make, but based on compensation actually earned to date.
No other contributions
Unlike SEP contributions, the only contributions permitted to be made to the SIMPLE IRA account of each employee are the elective deferrals made by that employee and the employer's match or non-elective contribution on behalf of that employee. Therefore, separate IRA plans must be established to hold SIMPLE money! Until the IRS issues guidance, it is unclear how this rule will impact a SIMPLE IRA that holds uncorrected excess deferrals.
Timing of contributions
Elective deferral contributions must be made to the employee's SIMPLE IRA as of the earliest date on which such contributions can reasonably be segregated from the employer's general assets, but no later than 30 calendar days following the last day of the month after being withheld from the employees' wages.
Employer non-elective or matching contributions must be made to the SIMPLE IRA accounts of each employee no later than the employer's tax filing deadline, including extensions.
IRA deduction limitations
Under a SIMPLE plan an employee will be treated as an active participant for purposes of the regular IRA contribution deductibility rules.
Tax treatment
Contributions to a SIMPLE IRA are excludible from federal income tax and not subject to federal income tax withholding.
Matching and non-elective contributions are not subject to FICA or FUTA and are not reported on the employee's Form W-2.
Tax Treatment of distributions
Distributions from a SIMPLE IRA are taxed in the same manner as any distribution from an IRA. This means that these distributions will be taxed at ordinary income tax rates by the payee or distributee, whichever the case may be. However, if an employee withdraws any amount from his/her SIMPLE IRA during the two-year period beginning on the date such employee first participated in the plan, the normal 10% additional income tax under Code Section 72(t) shall be increased to 25%. However, the other exceptions to the 10% tax (age 59 1/2, death, disability, etc.) will avoid this 25% additional tax for distributions received before the two-year period has expired.
Two-year holding period defined
For determining whether the 25% additional tax applies (or whether rollovers and transfers can be made to non-SIMPLE IRAs, explained below), the two-year period begins on the first day on which contributions made by the individual's employer are deposited into the individual's SIMPLE IRA.
The trustee or custodian is responsible for tracking this two-year period. Form 1099-R will be coded "S" to indicate that a distribution had occurred within the first two years. However, a trustee or custodian is permitted to prepare this report on the basis of its own records with respect to the SIMPLE IRA account. The trustee or custodian may, but is not required to, take into account other adequately substantiated information regarding the date on which an individual first participated in any SIMPLE plan maintained by the individual's employer.
Note: The Roth IRA regulations contain a clarification to the two-year holding period applicable to SIMPLE IRAs. The Roth IRA regulations state, "This 2-year period of section 408(d)(3)(G) applies separately to the contributions of each of an individual's employers maintaining a SIMPLE IRA Plan." This clarification is not found in any SIMPLE guidance released as of this date.
Example. Ruby worked for Company A during 2001 and began participating in Company A's SIMPLE IRA Plan on June 3, 2001. She then changed jobs and began participating in Company B's SIMPLE IRA Plan on November 14, 2001. Contributions relating to Company A's plan would meet the two-year period on June 3, 2003. Contributions relating to Company B's plan would meet the two-year period on November 14, 2003.
Rollovers from SIMPLE IRAs
Rollovers will be permitted from one SIMPLE IRA to another SIMPLE IRA under the same rules for any IRA to IRA rollover. Thus, a 60-day rollover from one SIMPLE IRA to another SIMPLE IRA would be subject to the "1 rollover per each consecutive 12-month period" rule.
However, a rollover to another IRA will be permitted only after the two-year holding period discussed above. If the participant (regardless of age) takes a distribution from a SIMPLE IRA and, before the expiration of the two-year period, rolls such distribution to another IRA (other than a SIMPLE IRA), such rollover contribution cannot be treated as a tax-free rollover and thus is includible in the participant's income.
The Roth IRA regulations make clear that SIMPLE IRAs may be converted to Roth IRAs in the same manner as traditional IRAs. However, a SIMPLE IRA must first meet the two-year holding requirement before it can be converted. Additionally, SIMPLE contributions may not be made to a Roth IRA.
Transfers from SIMPLE IRAs
During the two-year period discussed above, an amount in a SIMPLE IRA can be transferred to another SIMPLE IRA in a tax-free, trustee-to-trustee transfer. If, during this two-year period (regardless of the participant's age), an amount is paid from a SIMPLE IRA directly to the trustee or custodian of an IRA that is not a SIMPLE IRA, the payment cannot be treated as a tax-free transfer or rollover and thus is taxable to the participant. The payment is a distribution from the SIMPLE IRA and a contribution to the other IRA that does not qualify as a rollover or transfer contribution. Such amount would be subject to the regular IRA contribution rules of Code Section 219 (generally $2,000) and thus could be subject to the 6% excise tax on excess IRA contributions.
This also implies that if a trustee or custodian is requested by the participant to transfer an amount to an IRA that is not a SIMPLE IRA before the expiration of the two-year period and the participant is under age 59 1/2, the trustee or custodian must report such amount as a distribution on Form 1099-R, coded "S." After the two-year period has expired, transfers can be made from a SIMPLE IRA to any other IRA.
Nondiscrimination testing and
top-heavy rules
SIMPLE Accounts are not subject to the top-heavy rules, ADP testing, or the 50%t participation rate applicable to SARSEPs.
ERISA implications
ERISA Section 404(c)(2) was amended to define when a participant or beneficiary is treated as "exercising control" over the assets in the account. Such control shall occur upon the earlier of:
1. An affirmative election with respect to the initial investment of any contributions;
2. A rollover to any other SIMPLE retirement account or IRA; or
3. One year after the SIMPLE retirement account is established.
Prior to that time, the employer is subject to the general ERISA requirements regarding the investment of plan assets.
Other rules
This article does not address all of the rules applicable to SIMPLE plans and SIMPLE IRA arrangements. For example, SIMPLE IRA Plan documentation for the employees, summary descriptions, annual participant statements, annual reporting to the IRS, veterans' reemployment rights, notification and reporting requirements of the employer, and the use of a designated financial institution (DFI) are not discussed. In most cases, the bonding rules do not apply to SIMPLE plans.
Treatment of excess elective deferrals
When contributions are made in excess of the amounts permitted, or when an employer does not qualify to establish or maintain a SIMPLE plan an excess contribution is created. For example, what happens if the employer has an existing SIMPLE IRA in calendar year 2000 which has been funded and then adopts a defined benefit plan for the year, an overlapping year, or has a short plan year falling within that calendar year? Generally, an employer cannot make contributions under a SIMPLE IRA Plan for a calendar year if the employer, or a predecessor employer, maintains a qualified plan (other than the SIMPLE IRA Plan) under which any of its employees receives an allocation of contributions (in the case of a defined contribution plan) or has an increase in a benefit accrued or treated as an accrued benefit under Code Section 411(d)(6) (in the case of a defined benefit plan) for any plan year beginning or ending in that calendar year. (In applying these rules, transfers, rollovers or forfeitures are disregarded, except to the extent forfeitures replace otherwise required contributions.) However, an employer can make contributions under a SIMPLE IRA Plan for a calendar year even though it maintains another employer-sponsored plan when that other plan covers employees covered under a collective bargaining agreement for which retirement benefits were the subject of good faith bargaining and the SIMPLE IRA Plan excludes these employees, and under the grace period rules previously discussed when there is an acquisition, disposition, or other similar transaction. In most cases, the adoption of a defined benefit plan would cause the SIMPLE IRA contributions for such year to become excess contributions. The SIMPLE rules are silent regarding any required notification to employees that the SIMPLE IRA is, effectively, being discontinued for such year. It would seem prudent, however, to inform the employees that contributions under the SIMPLE plan are "excess" contributions and will be reflected on Form W-2 (see below). It also would seem prudent to inform the employees of the amounts that should be withdrawn (or recharacterized) with any gain thereon before the due date of the employee's federal income tax return, and the effect of doing so and of removing the excess amount after the due date of the return. Arguably, if no contributions have been made for such year, the plan could be terminated; otherwise, any amendment to a SIMPLE plan can be effective only at the beginning of a calendar year and must conform to the content of the plan notice for the calendar year.
With only one exception, none of the rules or guidance issued to date suggests how the excess is treated, or specifies any available correction method. Since excess contributions are not deductible, the employer may be subject to a 10% penalty tax unless corrected. The correction methods applicable to qualified plans do not seem to apply or are inadequate for SIMPLE plan purposes because the employer has no control over the SIMPLE IRA, which belongs to the employee. Neither can excess amounts be used by the employee as a traditional IRA contribution because such contributions must be made to a traditional IRA (which term does not include a SIMPLE IRA). It would seem that the regular IRA excess contribution rules would apply to the employee since a simple retirement account is "an individual retirement plan (as defined in section 7701(a)(3)..." which must also meet additional rules.
Without formal guidance regarding the correction of excess contributions under a SIMPLE IRA, many financial organizations will not make a corrective distribution. Instead, they consider any withdrawal as an age-based distribution taxable when withdrawn and subject to the 25% tax penalty (unless an exception applies). These organizations suggest that the money either should be left in the account (apparently they do not feel the 6% excise tax under Code Section 4973 is an issue) or taken out and become subject to normal withdrawal taxes and penalty rules. Such amounts also are treated as taxable distributions when withdrawn. IRS spokespeople have even said that a contribution of a penny more than is allowable would invalidate the entire program, a result not likely to be sustained in a court of competent jurisdiction. Then again, anything is possible.
Specific instructions for Form W-2 (2000), box 13, relating to 401(k) plan excesses, provide that the entire elective contribution is reported in box 13. The instructions specifically state, "The excess is not reported in box 1." [Emphasis added.]
On the other hand, the back of Form W-2, Instructions (for completing box 13), states the following when using Code S: "Employee salary reduction contributions under a section 408(p) SIMPLE (not included in box 1)." Arguably, excess contributions under a SIMPLE are to be reported in boxes 1, 3, and 5, but should not be reflected in box 13. This approach also would seem to eliminate any employer penalty relating to nondeductible contributions by turning those amounts into personal contributions made by the employee. Since traditional IRA contributions are not permitted to be made into a SIMPLE IRA, the employee should remove the entire amount in accordance with the general rules for removing excess IRA contributions under Code Sections 408(d)(4) and 408(d)(5). This approach would also seem to eliminate the distinction between excess employer contributions and excess employee contributions, but leaves open the issue of income tax withholding, FICA, and FUTA. The employee also would have to explain why the amount shown on Form 5498 issued by the trustee or custodian should not be subject to tax (having also been reflected in box 1 of Form W-2).
A distribution of excess IRA contributions, made within the time for filing the individual's tax return for the year in which an excess IRA contribution occurs, is not included in gross income nor subject to the penalty tax, provided that the interest or other income that was earned on the excess IRA contribution is also withdrawn. The interest or other income attributable to the distribution is taxable in the year that the contribution was made and is subject to the premature distribution penalty tax if the participant is under age 59 1/2 (unless another exception applies).
If the excess IRA contributions are withdrawn after the due date of the individual's tax return, the excess amount is not includible in income, regardless of whether the interest or other income earned on the excess contribution is also withdrawn. The $2,000 limit applicable to corrective IRA distributions made after the due date of the return is increased by the amount of the Code Section 415 dollar limit (currently $30,000) or the amount of the SEP contributions if less; no increase, however, is provided for excesses that originated under a SIMPLE plan returned after the due date.
Excess IRA contributions are subject to a 6% tax for each year that the excess remains in the IRA. The tax, however, cannot be more than 6% of the value of the IRA determined as of the end of the year. Excess IRA contributions should be removed. The excise tax is reported by the individual in Part II of Form 5329. Individuals report the 10% premature distribution penalty tax in Part I of Form 5329. Also see Publication 590 for a discussion of exceptions to the age 59 1/2 rule.
Excess IRA contributions (including any gain thereon also) can be re-characterized (treated as if contributed to a traditional IRA or Roth IRA), but this would provide a remedy only for amounts not in excess of $2,000, at best.
It could be argued, however, that an excess should be treated in the same manner as under a SEP. Under a SEP, contributions in excess of 15% of an individual's taxable compensation are includible in income and reported by the employer on Form W-2 as "wages" under Code Section 402(h). No comparable provision applies in the case of a SIMPLE, nor does the 15% of compensation limitation apply. Excess salary reduction contributions under a SARSEP are subject to special notification and timing rules, which in some cases treat the amount as an excess only after the notification is provided to the employee. In some cases, the entire arrangement is invalidated if no notification is provided. As was previously stated, there are no notification requirements applicable to excesses under a SIMPLE plan.
It seems evident that the IRS is hesitant to address this issue and other issues relating to the proper administration of the tax laws relating to distributions and the correction of excess contributions. Perhaps this is because the Code does not provide a remedy. Even if the IRA rules apply to excesses, there remain issues and questions that would need to be resolved. Upon the payment of a substantial user fee, it might be possible to get an answer by requesting a private letter ruling (PLR). It appears as though the IRS does not believe that this is a recurring problem. But clearly, after four years, the IRS could have provided some guidance. The making of excess contributions, regardless of the cause, may turn a SIMPLE IRA Plan into a "COMPLEX"! *