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Excess matching contribution in SIMPLE IRA


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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 (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 with respect to 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 It would also seem prudent to inform the employees of the amounts that should be withdrawn (or recharacterized to a traditional IRA) with any gain thereon before the due date of the employee’s Federal income tax return and the effect of doing so and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 only be effective at the beginning of a calendar year and must conform to the content of the plan notice for that calendar year.

With only one exception, none of the rules or guidance issued to date suggests how the excess is treated, nor specify any available correction method. Since excess contributions are not deductible, the employer may be subject to a 10 percent 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 percent tax penalty (unless an exception applies). These organization suggest that either the money should be left in the account (apparently they do not feel the 6 percent excise tax under Code Section 4973 is an issue or the 10% penalty tax on the employer under Code Section 4972) or taken out and be subject to normal withdrawal taxes and penalty rules. Such amounts are also 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 Instruction 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 box 1, 3, and 5, but should not be reflected in box 13. This approach would also seem to eliminate any employer penalty relating to nondeductible contributions by turning those amounts into "wages" (and consequently, 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 would also 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). Distributions of gain, may however, be subject to the 10% or 25% tax,unless an exception applies.

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 59½ (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 percent tax for each year that the excess remains in the IRA. The tax, however, cannot be more than 6 percent 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 percent premature distribution penalty tax in Part I of Form 5329. Also see Publication 590 for a discussion of exceptions to the age 59½ rule.

Excess IRA contributions (including any gain thereon) can also be recharacterized (treated as if contributed to a traditional IRA or Roth IRA), but this would only provide a remedy 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 percent of an individuals 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 percent 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 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 so because the Code does not explicity provide a remedy in Code Section 408(p). Even if the IRA rules apply to excesses, there remains 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”!

Hope this helps.

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