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A SIMPLE IRA Checkup: Short-Term Decisions, Long-Term Outcomes

A SIMPLE IRA Checkup: Short-Term Decisions, Long-Term OutcomesA SIMPLE IRA is inexpensive, fast to establish and relatively easy to maintain. For these reasons, it is often a go-to plan for small businesses. Yet, a SIMPLE IRA may fall short of satisfying long-term needs for retirement accumulation, income tax management in the accumulation years and tax diversification in retirement. Let us review its key features, benefits, potential shortcomings and alternatives.
 

Who Can Participate in a SIMPLE IRA plan?

Participation is open to any employee (including a self-employed individual) who:

  1. Earned at least $5,000 during any two years preceding the current calendar year, and
  2. Expected to earn at least $5,000 in the current calendar year

However, an employer may exclude union employees and nonresident alien employees without U.S. compensation.
 
Unlike in a 401(k) plan, where an employee may be required to be age 21 and complete one year of service (12 months or 1,000 hours), age and hours of employment are not included in eligibility considerations, making a SIMPLE IRA less attractive for businesses with a large number of part-time employees.
 

Contribution Rules

SIMPLE IRA contributions include employee salary deferrals and company contributions. Plan participants may contribute up to $12,500 ($15,500 if age 50 or older) and is subject to cost-of-living adjustments (COLA).
 
The employer has two choices for contributing:

  1. A 2% nonelective employer contribution, where employees eligible to participate receive an employer contribution equal to 2% of their compensation (limited to $270,000 for 2017 [$275,000 for 2018] and subject to COLA for later years), regardless of whether they make their own contributions.
  2. A dollar-for-dollar match up to 3% of compensation, where only the participating employees who have elected to contribute will receive an employer matching contribution.

 
The contribution type and amount for each upcoming year must be decided and communicated to participants annually by November 2. When a business owner is interested in saving more than $15,000–$20,000 per year, it is time to consider a plan upgrade.
 

The One-Plan Requirement

When a company has a SIMPLE IRA, it has to be the only plan maintained in the calendar year; it may not be stopped in favor of another plan, no matter how robust or advantageous to participants. This rule prohibits businesses with SIMPLE IRAs, and related employers, from installing complementary plans to increase savings. Alternative plan arrangements, a 401(k) for example, allow the use of add-on plans such as a profit-sharing or a cash balance plan. These plan combinations increase the deductible contribution potential above the limits possible with a standalone 401(k).
 
For example, a 401(k) profit-sharing plan improves on the contribution limits of a SIMPLE IRA in two ways.

  1. A 401(k) plan offers a contribution increase of $5,500 – $8,500 by increasing the deferral limit to $18,000 plus a $6,000 catch-up for those 50 or older ($18,500 & $6,000 in 2018).
  2. The profit-sharing component delivers both the higher deductible limits and the ability to determine the level of contributions with perfect The total 401(k) profit-sharing contribution limit per individual is the lesser of the participant’s compensation or $54,000 ($60,000 for those eligible to make catch-up salary deferrals). These numbers received a small step-up for 2018: $55,000 and $61,000 respectively.

 
Typically, when a SIMPLE IRA is replaced with a 401(k) profit-sharing plan, business owners’ deductible contribution potential and tax savings may double. If the $54,000 contribution is not enough, a business sponsoring a 401(k) can add an additional layer, a cash balance plan. Depending on age and income, this approach may unlock contribution potential in excess of $100,000, a level unattainable in a SIMPLE IRA.
 

Accessibility and Withdrawal Rules

A SIMPLE IRA is not a particularly effective employee retention tool. For example, SIMPLEs do not have a vesting provision or may not require that an individual be employed for the entire plan year to receive a contribution. Vesting rules allow the plan to recapture non-vested balances of participants who separate from service before working a requisite number of years, typically six for match and profit-sharing contributions.
 
Withdrawals from a SIMPLE IRA are available at any time, for any reason. No distribution triggering events are required. However, when taken before age 59½, distributions are subject to a 10% penalty in addition to ordinary income taxes; the penalty increases to 25% if the account is accessed within two years from the first deposit. For these reasons, a SIMPLE IRA may not be the best tool to help the business in recouping some of the hidden costs associated with employee turnover.
 
SIMPLE IRAs offer a limited short-term access to savings by way of an indirect rollover. Through an indirect rollover, a participant can access the SIMPLE IRA account value without tax consequences, provided that the amount is redeposited within 60 calendar days of receipt. Remember, however, that a one-per-year per individual limit applies to this transaction.
 
Non-IRA plans may offer an important accessibility feature: a loan up to the lesser of 50% of the vested account balance or $50,000. Loans are not taxed as long as they are repaid within five years with interest, and payments occur at least quarterly. A longer term is available for home purchases.
 

Taxation Rules

Another important consideration is tax management. All contributions made to a SIMPLE IRA plan are pre-tax, which means that every dollar deposited into the account, along with earnings, will be subject to taxation upon withdrawal.
 
401(k) plans offer a choice between traditional (pre-tax) contributions that grow tax-deferred and are subject to income tax at withdrawal, and Roth 401(k) contributions that are made with after-tax dollars and offer access to tax-free growth and distributions (provided the distributions are qualified). Plan participants decide whether to make all contributions on a traditional or Roth basis or combine them as necessary.
 
Having a tax-free bucket of money in retirement in addition to pre-tax accumulation and savings subject to capital gains treatment expands the options to manage tax liabilities in retirement. The ability to make additional after-tax contributions and convert them immediately inside the plan to Roth, which is possible in a 401(k) plan, may be another reason to reconsider the SIMPLE IRA choice.
 

How We Can Help

Whether it is a contribution limit, exclusive plan rule, liquidity constraints, lack of tax diversification or ineffectiveness for employee retention purposes, the SIMPLE IRA may fall short of meeting small business owner needs. A side-by-side analysis of the available options may help your clients and prospects make an educated decision. Contact us to find out how we can help.
 

About Cetera® Advisor Networks

Cetera Advisor Networks LLC is an independent broker-dealer and registered investment adviser firm that utilizes a unique regional director model to support financial advisors through the entire life cycle of their business. As part of Cetera Financial Group®, a leading network of independent retail broker-dealers, Cetera Advisor Networks is able to build and support regional teams through local service, regional offices and a national home office, facilitating the success of financial professionals.

Cetera Advisor Networks is a member of the Securities Investor Protection Corporation (SIPC) and the Financial Industry Regulatory Authority (FINRA). For more information, see ceteraadvisornetworks.com.

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