Human Resources: The SIMPLE IRA: An Attractive Option for Smaller Businesses

The Savings Incentive Match Plan for Employees of Small Businesses (SIMPLE) is a retirement plan designed to help employees working for small businesses save for retirement on a tax-favored basis, while allowing employers current-year tax deductions. A SIMPLE Plan may use SIMPLE IRA accounts to receive plan contributions. Here are some questions and answers about the SIMPLE IRA retirement plan.

Q. What is a SIMPLE IRA Retirement Plan and what are its advantages?

A. A SIMPLE IRA plan is a type of "salary reduction" retirement plan for small businesses. Due to its basic design features, it is not subject to the complex eligibility and nondiscrimination requirements associated with traditional 401(k) plans or Salary Reduction-Simplified Employee Pension Plans (SARSEPs). Administrative and other plan costs, therefore, are minimized.

Another advantage of SIMPLE IRA plans, from an employer''s standpoint, is that SIMPLE IRA plans are not subject to annual reporting and testing requirements. Also, the employer will not be subject to fiduciary liability resulting from an employee exercising control over the assets in the employee''s SIMPLE IRA account.

Q. Who can adopt a SIMPLE IRA plan?

A. Businesses are eligible to adopt a SIMPLE IRA plan if they employ 100 or fewer employees who each received at least $5,000 in compensation for the preceding year and do not maintain another employer-sponsored retirement plan. This includes corporations, partnerships, sole proprietors, tax- exempt organizations and state or local governments or agencies.

Q. How does a SIMPLE IRA plan work?

A. A SIMPLE IRA plan allows employees to make pre-tax elective contributions to a SIMPLE individual retirement account (a SIMPLE IRA). Employee contributions may be any percentage (not over 100%) of total compensation (or net earned income) so long as the dollar amount contributed for any year does not exceed $7,0001 per year plus any allowable catch-up contributions. 2 Also, employers must contribute to employee accounts using one of two contribution formulas:

Under the matching contribution formula, employers are required to match employee contributions dollar-for-dollar up to 3% of each participating employee''s compensation. (A special rule allows employers to elect a lower percentage matching contribution rate but not less than 1% of each employee''s compensation. Employers may not elect to use a lower percentage for more than two out of any five consecutive years.)

Instead of making matching contributions, for any year, employers may select a non-elective contribution formula of 2% of compensation on behalf of each eligible employee and may, in addition, require that each such eligible employee actually receive at least $5,000 in compensation during the year, whether or not the employee made pre-tax elective contributions during the year. For this purpose, compensation taken into account may not exceed $200,000 (as indexed for inflation).

The employer must give written notice specifying the employer''s contribution formula for that year to every eligible employee at least 60 days before the start of the year.

SIMPLE IRA contributions may only be made to a SIMPLE IRA account. Except for rollovers from other SIMPLE IRAs, no other contributions may be made.

Q. Who is eligible to participate?

A. Generally, any employee who received at least $5,000 in compensation during any two prior years, and who is reasonably expected to receive at least $5,000 in compensation during the current year, is eligible to participate in a SIMPLE plan. An employer may elect more liberal eligibility rules. All SIMPLE contributions (employee and employer matching) must be fully vested when made.

Q. How are SIMPLE IRA contributions treated for federal income tax purposes?

A. All SIMPLE IRA contributions are tax deductible for the employers. In addition, contributions to a SIMPLE IRA account are excluded from an employee''s income for federal income tax purposes in the year contributed, and the assets of a SIMPLE IRA account may grow on a tax-deferred basis. The employee''s pre-tax contributions are included in income for Social Security (both retirement and Medicare benefits) and unemployment taxes, if applicable. Thus, participation in a SIMPLE IRA plan will not reduce an employee''s Social Security benefits.

Q. How are distributions from a SIMPLE IRA plan taxed?

A. Generally, distributions from a SIMPLE IRA plan are taxed under the rules applicable to IRAs. However, a 25% early distribution penalty applies to distributions taken prior to the two-year anniversary of initial participation, unless the employee is age 59 1/2 or older or another exception applies. After the two-year period, the penalty tax rate is 10%. Tax-free rollovers may be made from one SIMPLE account to another.

Q. Can a SIMPLE IRA account be rolled over to an IRA?

A. If two years have passed since the employee first participated in the SIMPLE IRA plan, a SIMPLE IRA may be rolled over to a Traditional IRA on a tax-free basis. A SIMPLE IRA account may also be converted to a Roth IRA if the employee''s modified adjusted gross income does not exceed $100,000 and two years have passed since the employee first participated in the SIMPLE IRA plan. However, any future employee and employer contributions under the SIMPLE IRA Plan may only be made to a SIMPLE IRA account.

To Learn More If you would like to learn more, please write care of Jason Wyatt, Associate Vice President, Morgan Stanley at jason.wyatt[at]morganstanley.com.

This article does not constitute tax or legal advice. Consult your tax or legal advisor before making any tax- or legally-related investment decisions. This article is published for general informational purposes only and is not an offer or solicitation to sell or buy any securities or commodities. Any particular investment should be analyzed based on its terms and risks as they relate to your individual circumstances and objectives.

1 8,000 for 2003, $9,000 for 2004, $10,000 for 2005, subject to cost-of-living adjustments for later years. Under a sunset provision in the 2001 tax act, these enhanced limits will expire in 2011 unless Congress extends the act.

2 Eligible employees who are at least age 50 by the last day of the year may defer an additional $500 for 2002. The catch-up contribution limit increases by $500 a year until reaching $2,500 for 2006 and later years. Catch-up contributions are also subject to the sunset provision in the tax law discussed in the note above.