Definition of net earnings: Net earnings must be from self-employment where your personal services are a material income-producing factor. "Net earnings" equals your business gross income, minus allowable deductions from that business (including contributions to the plan for your employees), reduced by the tax deduction for your self-employment tax. Net earnings are also reduced by the deduction for contributions you make for yourself. This adjustment is made indirectly by reducing the contribution rate called for in the plan when you figure the maximum contribution for yourself. Thus, for example, the 2% contribution becomes a contribution of 1.9608% of net earnings before the contribution.

For more information see Publication 560 Retirement Plans for Small Business (SEP, Keogh, and SIMPLE Plans).

A SIMPLE plan is a written salary reduction arrangement that allows a small business (an employer with 100 or fewer employees) to make elective contributions to a simple retirement account on behalf of each eligible employee. An eligible employer is not allowed to maintain another retirement plan.

Setting Up a SIMPLE Plan

If an employer has 100 or fewer employees (who received at least $5,000 of compensation from the employer for the preceding year), the employer may be able to set up a SIMPLE retirement plan on behalf of eligible employees. The plan can be either:

•An IRA for each eligible employee, or •Part of a qualified cash or deferred arrangement (a 401(k) plan).

The SIMPLE plan must be the only retirement plan of the employer to which contributions are made, or benefits are accrued, for service in any year beginning with the year the SIMPLE plan becomes effective.

Under the qualified salary reduction arrangement the employer's contributions on behalf of the employee (elective deferrals) are stated as a percentage of the employee's compensation and are limited to $6,000. The dollar limit is indexed for inflation in $500 increments.

Under the qualified salary reduction arrangement the employer is also required to make either a matching contribution to the simple retirement account on behalf of each employee who elects to make elective deferrals, or a nonelective contribution to the simple retirement account on behalf of each eligible employee. These two methods for determining the employer contribution formula are explained under Dollar-for-dollar employer matching contributionsand 2% nonelective contributions.

Contributions to a SIMPLE Plan are deductible by the employer and are excluded from the gross income of the employee.

Definitions

SIMPLE retirement account. The simple retirement account of an eligible employee is an individual retirement plan that can be either an individual retirement account or an individual retirement annuity, as described in Publication 590. Employees' rights to the contributions cannot be forfeited.

A SIMPLE plan can also be set up as a 401(k). See Publication 560 for information on how to adopt a SIMPLE plan as part of a 401(k) plan.

Qualified salary reduction arrangement. An employee eligible to participate in the SIMPLE plan may elect (during the 60-day period before the beginning of any year) to have the employer make contributions (called elective deferrals) to the simple retirement account on his or her behalf. An employee who so elects may also stop making elective deferrals at any time during the year. The employer is required to match the employee's contributions or to make nonelective contributions. No other types of contributions are allowed under the qualified salary reduction arrangement.

Eligible employer. Any employer who has 100 or fewer eligible employees in any year can establish a SIMPLE plan provided the employer does not maintain another employer-sponsored retirement plan.

Eligible employee. Any employee who receives at least $5,000 in compensation during any 2 years preceding the plan year can elect to have his or her employer make contributions to a simple retirement account under a qualified salary reduction arrangement. The employee must be expected to earn at least $5,000 during the calendar year.

Compensation. Compensation for employees is the total amount of wages required to be reported on Form W-2, plus elective deferrals. For the self-employed individual, compensation is the net earnings from self-employment (without regard to any contribution made to the SIMPLE plan for the self-employed individual).

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Any SIMPLE elective deferrals relating to an employee's wages under a salary reduction arrangement are included in the Form W-2 wages for social security and Medicare tax purposes only.

Contribution Limits

Contributions are made up of employee elective deferrals and employer contributions. The employer is required to satisfy one of two contribution formulas: the matching contribution formula or a two-percent nonelective contribution. No other contributions can be made to the SIMPLE plan. These contributions, which are deductible by the employer, must be made timely.

Employee elective deferral limit. The amount that the employee elects to have the employer contribute to a simple retirement account on his or her behalf (elective deferrals) must not exceed $6,000 for any year and must be expressed as a percentage of the employee's compensation.

Dollar-for-dollar employer matching contributions. The employer is required to match all eligible employees' elective contributions, on a dollar-for-dollar basis, up to 3% of the employee's compensation.

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If the employer elects a matching contribution that is less than 3%, the percentage must not be less than 1%. The employer must notify the employees of the lower match within a reasonable time before the employee's 60-day election period for the calendar year. A percentage less than 3% cannot be elected for more than two years during a five-year period.

2% nonelective contributions. In lieu of the dollar-for-dollar matching contributions, the employer may elect to make nonelective contributions of 2-percent of compensation on behalf of each eligible employee. Only $160,000 of the employee's compensation can be taken into account to figure the contribution limit.

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If the employer elects this 2% contribution formula, he or she must notify the employees timely (within the employee's 60-day election period described earlier).

Time limits for contributing funds. The employer is required to contribute the employee's deferral to the SIMPLE account within 30 days after the end of the month for which the payments to the employee were deferred. The employer's matching contributions to the SIMPLE plan, however, are required to be made by the tax return filing deadline, including extensions, for the taxable year that begins with or within the calendar year for which the contributions are made.

Distributions (Withdrawals)

Distributions from a SIMPLE retirement account are subject to IRA rules and are includible in income when withdrawn. Tax-free rollovers can be made from one SIMPLE account into another SIMPLE account or into an IRA. Early withdrawals generally are subject to a 10% (or 25%) penalty.

See Publication 590 for information about IRA rules, including those on the tax treatment of distributions, rollovers, required distributions, and income tax withholding.

Exceptions. A rollover to an IRA can be made tax free only after a 2-year participation in the SIMPLE plan. A 25% penalty for early withdrawal applies if funds are withdrawn within 2 years of beginning participation.

Employee notification. The employer who sets up a SIMPLE plan must notify each eligible employee of his or her opportunity to make contributions under the plan. The employer must also notify all eligible employees of the contribution alternative that was chosen. This information must be provided before the beginning of the employee's 60-day election period.

Where to find out more. This chapter does not contain all the rules and exceptions that apply to a SIMPLE-IRA or a SIMPLE 401(k) plan. See Publication 560 for additional information, including reporting and disclosure requirements for SIMPLE plans.

You may also get the following forms and their instructions:

•5304-SIMPLE, Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) (Not Subject to the Designated Financial Institution Rules), and •5305-SIMPLE, Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) (for Use With a Designated Financial Institution).