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How Do I Avoid A Simple IRA Penalty?

The SIMPLE IRA may very well be the best, most useful small company retirement plan available today.  Generous maximum contribution limits, immediate vesting, simple administration, and low matching formulas for the employer make it a pretty attractive option for most small businesses.  First, let’s briefly take an aerial view of the SIMPLE IRA.

What Is A SIMPLE IRA?

First things first, the SIMPLE is available to all companies (for-profit and not-for-profit) with 100 employees or fewer.  Employers have the option on how to contribute to employees’ accounts.  They may either match contributions made by employees up to 3% of each employee’s annual salary, or employers may contribute 2% to every employee’s SIMPLE IRA account, without consideration of employee’s contributions.  

The SIMPLE IRA was enacted in 1996 out of Congressional legislation.  SIMPLE IRA’s are not subject to ERISA.

It All Sounds Good So Far, What Is The Downside?

Like every relationship with the IRS, there are downsides.  Most notably are the staggering 25% penalty possibilities for early withdrawal from a SIMPLE IRA.  But there are options on when a SIMPLE IRA owner may take a distribution out of his or her account.  Those instances include:

  • The account owner dies or becomes permanently disabled.
  • The account owner reaches the age of 59½
  • The distribution is taken to pay higher education costs.
  • First-Time home purchase, and the distribution is less than $10,000
  • SEPP Payments from a 72(t)
  • The distribution is used to pay an IRS levy
  • Un-reimbursed medical expenses, in excess of the Schedule A threshold – currently set at 10% of Adjusted Gross Income
  • Qualified military reservist called to active duty

So, do you meet any of above exceptions?  If not, you will likely be subject to a 10% early withdrawal penalty on withdrawals out of your SIMPLE IRA.  How much is the penalty?  Well, if you take a withdrawal out of your SIMPLE IRA within the first two years of your first contribution, then you’re on the hook for a 25% penalty.  Not to mention having to actually pay Federal Income Tax on the withdrawal.  If you wait until two years to take your non-qualified withdrawal, then you will still incur a 10% penalty, and you will still have to pay federal income tax on the withdrawal.  If you’re in a state that has a state income tax, then they’ll want a piece as well.

It’s also important to note that SIMPLE IRA’s contain different rollover/transfer rules than other IRA’s.  SIMPLE IRA assets can be rolled over / transferred to a traditional IRA after two full years of the first contributions.  However rollovers / transfers from a SIMPLE IRA to another SIMPLE IRA do not have that restriction.

Like any qualified plan, risks abound.  Make certain that you consult your CPA for any additional questions that you may have.