SIMPLE IRA Tax Rules Explained: Employee Contributions & Benefits

The Savings Incentive Match Plan for Employee (Simple) IRA tax deferred savings account provides employers with 100 or fewer employees an easy way to supply benefits to those employees. Each employee sets up a tax deferred IRA account with a plan administrator.

Employee Tax Rules

The employee can elect to contribute up to the annual maximum contribution limit to the account on a tax deferred basis. The employee will not pay taxes until the sums are withdrawn from the account. The annual maximum contribution varies by year. In 2009, the maximum was $11,500 for those under 50 and $14,000 for those over 50. If the employee withdraws funds from the account prior to the minimum qualified age, he or she will owe a 10 percent penalty in addition to taxes on the income.

Employer Tax Rules

The employer must notify the employees of all plan features and their eligibility to participate in the SIMPLE plan. Then, the employer must contribute funds up to its predetermined amount, decided upon by the company, within each tax year. The employer can deduct this amount from annual taxable income. The only strict rule is that the contributions must be made within the tax year in order to be deducted. 

What are the eligibility requirements for opening a SIMPLE IRA plan?

The basic requirements for setting up a SIMPLE IRA plan are easy to follow:

You, as the employer, must have 100 or fewer employees who earned at least $5,000 last year. You can count all of your employees even if you do not intend to make all of them eligible for the plan immediately. You must not have any other plans for your employees to receive retirement benefits, including these:

• Union plans
• SEP IRA plans
• Qualified plans like 401k's and 403b's
• Annuity plans
• Pension trusts
• Federal or state pension plans

If your company meets these requirements, even if you are the sole employee, you may be eligible to set up a SIMPLE IRA for your company.

What is the SIMPLE IRA withdrawal penalty?

If you make any early withdrawal from a retirement account, including a SIMPLE IRA withdrawal, you may be subject to a penalty in addition to regular tax payments on the income. On a tax-deferred account, you will always have to pay income tax on the back end when you withdraw funds. This category includes most IRAs other than the Roth IRA. If the withdrawal is made before you reach the minimum qualified age of 59 1/2, you will additionally be subject to a 10 percent flat penalty on the entire withdrawal amount, regardless of the size of that withdrawal.