Take-Away: A Savings Incentive Match Plan for Employees (a SIMPLE IRA) is a cross between a qualified plan and a traditional IRA. Sometimes a SIMPLE IRA follows traditional IRA rules, and at other times a SIMPLE IRA follows qualified plan rules. That blend between the two types of retirement plans (IRA and qualified plan) and their rules means that a SIMPLE IRA can often cause confusion or erroneous assumptions. In addition, SIMPLE IRAs carry some unique rules which can lead to mistakes in contributions and distributions.

Background: A SIMPLE IRA or 401(k) is a plan that is sponsored by an employer. A SIMPLE plan can either be an IRA or a 401(k) account.

SIMPLE IRA Contributions: An individual may make salary deferral contributions of up to $13,000 plus receive employer contributions in the SIMPLE plan. In addition, the participant can also contribute up to $6,000 to a traditional or Roth IRA. Contributions to a 401(k) can also be made (up to $56,000 in a calendar year) but total salary deferrals by the employee to multiple qualified plans cannot exceed $19,000 in a calendar year (ignoring catch-up contributions if  the participant is older.) Contribution limits can be imposed if the employee participates at the same time in a 401(k), 403(b) or 457(b) plan.

SIMPLE IRA Distributions: With a couple of ‘big-time’ caveats, distributions from a SIMPLE IRA are like distributions from a traditional IRA. If the employee is over age 70 ½, and must take required minimum distributions (RMDs), the balance of the SIMPLE IRA is bunched with any other traditional IRAs in order to determine the employee’s RMD for the calendar year.

Pro-rata Rule Applies to SIMPLE IRA Distributions: Under the pro-rata rule, all of the employee’s retirement IRA accounts, i.e. traditional IRAs, SIMPLE IRAs, and even Simplified Employee Pension (SEP) IRAs,  are aggregated and treated as a single retirement account when it comes to calculating and taxing RMDs. The tax-free portion of a distribution is calculated by comparing the value of the total after-tax contribution to the taxable portion of the employee’s collective IRAs. Consequently, similar to traditional IRAs, if the employee has made after-tax contributions to a traditional IRA, and that employee also has a SIMPLE IRA, any RMDs from the SIMPLE IRA will consist of a portion of the after-tax contributions that were deposited into the employee’s traditional IRA.

Example: Donald has a traditional IRA with a balance of 100,000, of which $10,000 reflects after-tax contributions made by Donald. Donald also has a SIMPLE IRA with a balance of $25,000. If Donald takes an IRA distribution of $30,000, a portion will not be taxed, or $2,400. [$10,000 (after-tax contribution) divided by $100,000 (traditional IRA) + $25,000 (SIMPLE IRA) = $125,000) = 8%.] Note that even though the after-tax contribution was made to Donald’s traditional IRA, if his distribution was taken from his SIMPLE IRA, the after-tax contribution portion would be considered in calculating how much of Donald’s SIMPLE IRA distribution will be taxed.

Special Penalty for SIMPLE IRA Early Distributions: Like a traditional IRA, any distributions taken from a SIMPLE IRA prior to the employee being age 59 ½ will be subject to the early distribution penalty. And consistent with traditional IRAs, some statutory exceptions to the 10% penalty apply to ‘early’ distributions from a SIMPLE IRA, e.g. a distribution for a first-home purchase or payment of college tuition. However,  there is one other very large exception to the customary 10% penalty that is imposed on an ‘early’ distribution from a SIMPLE IRA that does not apply to a distribution from a traditional IRA. A pre-age 59 ½ distribution from a SIMPLE IRA is subject to a penalty of 25% (not 10%) when the funds are withdrawn during a 2-year holding or seasoning period after the SIMPLE IRA is opened. The two year period is calculated from the date that the employee’s first contributions are deposited to the SIMPLE IRA- the ‘test’ is based on days not calendar years.

Example: Moe, Larry  and Curly each work for a company that just sponsored a SIMPLE IRA in 2018.  Moe is age 46. Larry is age 62. Curly is age 54. Each of Moe,  Larry and Curly decide to take a $2,000 distribution from their respective SIMPLE IRAs.

Curly, age 54, will have to pay the 25% penalty, along with the income tax liability on the distribution, because Curly’s withdrawal from his SIMPLE IRA  is during the two-year seasoning

In Larry’s situation, his age 62 is important. Larry will not be subject to the 25% penalty even though he, too, took the distribution from his SIMPLE IRA during the same two-year seasoning period as did Curly. Larry will pay no penalty because he was over age 59 ½ when the distribution was taken by him from his SIMPLE IRA. Larry will have to pay income taxes on the distribution, but no penalty will be assessed.

How Moe spends his distribution is important. Moe uses his SIMPLE IRA distribution to pay his son’s college tuition obligation. Moe’s SIMPLE IRA distribution will be subject to income tax, just like any other traditional IRA distribution. But in Moe’s case, despite being age 46, he will not have to pay the 25% penalty, because Moe’s SIMPLE IRA distribution fit within one of the statutory exceptions that permit penalty-free IRA distributions for qualified higher education expenses.

Rollovers and Transfers of SIMPLE IRAs: Prior to 2015 a SIMPLE IRA could only accept a rollover from another SIMPLE IRA. That changed with the PATH Act, but only to a degree. Now a SIMPLE IRA can be rolled over and transferred to a traditional IRA, or ‘rolled-up’ into an employer’s qualified plan, but only after the two-year seasoning period has passed. If the employee attempts a rollover of her SIMPLE IRA during the two-year seasoning period, it will be treated as a taxable distribution from her SIMPLE IRA (plus the 25% penalty) and a contribution (not rollover) to the traditional IRA. In other words, the transfer of assets to the traditional IRA will not qualify as a rollover Consequently, after the two-year seasoning period, funds from a traditional IRA and employer qualified plans can be rolled into the SIMPLE IRA, and SIMPLE IRA funds can be transferred or rolled over to a traditional IRA or qualified plan.

Roth Conversions of SIMPLE IRAs: After the two-year seasoning period has passed, the employee can convert his/her SIMPLE IRA to a Roth IRA.

Required Minimum Distributions of SIMPLE IRAs: SIMPLE IRAs follow the same rules as traditional IRAs with regard to required minimum distributions. Accordingly, if the employee is over age 70 ½, he/she must take their first RMD by April 1 of the following calendar year.

‘Still Working’ Exception Unavailable: However, there is one big difference with regard to an employee who participates in an employer’s qualified plan and an employee who participates in a SIMPLE IRA ‘plan.’ An employee over age 70 ½ who is a participant in an employer’s qualified plan is not required to take a required minimum distribution (RMD) if that employee-participant does not own 5% or more of the employer, and that employee is ‘still working’ for the qualified plan sponsor. The employee-participant will have to take RMDs from their traditional IRA,. However, the employee will not have to take an RMD from their qualified plan account. While the SIMPLE IRA is an employer sponsored retirement plan, just like any other qualified plan, the ‘still working’ exception with regard to RMDs is not available to the owner of the SIMPLE IRA. As a result, the owner of the SIMPLE IRA, while ‘still working’, must nonetheless take a required minimum distribution from his/her SIMPLE IRA.

The ‘Revolving Door:’ These SIMPLE IRA distribution rules also create an anomaly. The SIMPLE IRA owner, if ‘still working’ as an employee and eligible to participate in the SIMPLE IRA plan, while over the age 70 ½, can continue to make contributions of his/her earned income to the SIMPLE IRA and possibly also receive contributions of their employer’s match,  yet at the same time he/she must also take RMDs from their SIMPLE IRA in the same year since he/she is then over 70 ½. As noted earlier, since all IRAs are aggregated for purposes of the owner calculating and taking their RMDs for the year, the ‘still working’ employee could satisfy his/her RMD obligation for the year by taking the entire RMD from an ‘outside’ traditional IRA while leaving their SIMPLE IRA intact.

Qualified Charitable Distribution Limitation: With regard to the ability of the SIMPLE IRA owner to use a qualified charitable distribution (QCD) to satisfy their RMD obligation for the calendar year, and possibly reduce their income tax liability at the same time, a SIMPLE IRA is not treated the same as a traditional IRA. A SIMPLE IRA cannot be the source of a QCD if a contribution was made to the SIMPLE IRA in the same calendar year. Therefore, if the ‘still working’ SIMPLE IRA owner is still contributing to his/her SIMPLE IRA, he/she, despite having to take an RMD for the year, will not be able to satisfy their RMD obligation with a QCD from the SIMPLE IRA. If the SIMPLE IRA owner has fully retired, and is no longer making contributions to their SIMPLE IRA, then the SIMPLE IRA can be the source used to make QCDs. Note, too, that if the two year seasoning period has passed, the SIMPLE IRA owner could directly transfer funds from their SIMPLE IRA to a traditional IRA, and then use that traditional IRA as the source of their QCD for the year.

Conclusion: Maybe they should be called Not-So-Simple IRAs so as to not mislead the general public. SIMPLE IRAs are admittedly a strange breed of retirement plan, along with unique rules that many are not aware of when it comes to taking distributions and the tax and penalty consequences when a distribution is taken prior to age 59 ½, like 2-year seasoning limitations and 25% penalties for ‘early’ distributions.  With regard to many of the rules when it comes to retirement plans, obviously neither Congress nor the IRS feels particularly compelled to simplify and streamline the rules to be applied to retirement plans. And as it always seems to be the case, making the assumption that a SIMPLE IRA is treated just like a traditional IRA since they are both IRAs can easily lead to traps and penalties at the owner’s expense. The bottom line is ‘go slow’ when you deal with SIMPLE IRAs and don’t make the  assumption that if it is called an IRA and looks like an IRA it must be treated as an IRA.