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Getting rid of a SIMPLE due to adoption of another plan


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OK, so an accountant wants to set up a 401(k) for a client who already has contributed to a SIMPLE. I told him the same thing I've said here, that it's not that easy and I just wouldn't bother. But he's bound and determined (with good reason, there's a substantial deduction at stake).

So here's the question - if someone (W-2 employee) has contributed, say, $5000 to the SIMPLE already, and wants to max on the 401(k), how do they do it? I think they should contribute another $17,500, and then report the $5000 as an excess deferral. (Interestingly, the payroll company is willing to recharacterize the $5000 as 401(k) contributions.) Then I think they go back to the SIMPLE custodian and request the money back as excess deferrals.

Any thoughts?

Ed Snyder

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  • 2 months later...

The adoption of the second plan will likely violate the exclusive plan requirement causing all contributions under the SIMPLE IRA plan for the plan year to be treated as excess contributions.

Unfortunately, the IRS has not issued formal guidance on excess contributions to a SIMPLE IRA. Form 5329 does not provide for such excesses to be reported on that form (nor does Form 5330 apply) because a SIMPLE IRA is not a traditional IRA, although it is an IRA (just like a SEP or a SARSEP). Therefore, many financial organizations will not make a corrective distribution from a SIMPLE IRA. Instead, they consider any withdrawal an age-based distribution taxable when withdrawn and subject to the 25 percent penalty tax (unless an exception applies). That being said, an amount contributed on behalf of an employee that is in excess of an employee’s benefit under the plan (or an elective deferral in excess of the annual dollar amount, including catch-up contribution, under Code Section 402(g) is treated as an “excess amount” under the IRS’s plan correction program. Under the EPCRS, the employer may be able to effectuate a return of the contributions (or possible pay a 10% fee and keep the assets in the SIMPLE-IRAs). And special 1099-R reporting rules apply. I would also request waiver any excise taxes that might apply (e.g., the 10% tax on nondeductible contributionms). Since Service approval is needed to waive excise taxes that would otherwise apply the accountant may want to wait until the following year before implementing a 401(k). That being said, for several thousand dollars (say $5-7k), the 401(k) plan could exist (instead).

The recharacterization of amounts in the SIMPLE-IRAs to a 401(k) trust may be a prohibited transaction and likely result in additional complications too nasty to even mention. I see no method of correction other than the EPCRS (service approval would be extremely prudent) and provide the trustee/custodian with any authorization it feels is needed to code the distributions as other than taxable and subject to the 25% early distribution penalty.

Hope this helps.

[see chapters 16 and 17 of the SIMPLE, SEP, and SARSEP Answer Book.]

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