By: Alison J. Cohen, Esq.

The SECURE 2.0 Act of 2022 (“SECURE 2.0”) made a number of changes impacting SIMPLE IRA and SIMPLE 401(k) Plans.  Some of these changes were effective as of January 1, 2023, and others kicked in earlier this year.  The Internal Revenue Service (“IRS”) provided guidance on these provisions as part of Notice 2024-02 (the “Grab Bag”) on December 20, 2023.  As we’ll discuss, the delayed release of the Grab Bag prevented proper implementation of some of these changes in 2023.

Mid-Year Conversions from SIMPLE to Safe Harbor 401(k)

SECURE 2.0, section 332 finally addressed the need to allow Employers to convert from a SIMPLE to a 401(k) plan mid-year, effective for plan years starting on or after January 1, 2024.  We have already seen a lot of activity on this, but there is definitely a need to clarify the key points.  As usual, the devil is in the details.

The first key point, and this is probably the biggest misunderstanding about this new change:  Internal Revenue Code (the “Code”) section 408(p)(11), allowing the mid-year change from a SIMPLE plan to a safe harbor 401(k) plan,  is an exception to the general rule under Code section 408(p)(2)(D) that says an employer is prohibited from maintaining both a SIMPLE IRA and another plan, contract, pension or trust described in Code section 219(g)(5)(A) or (B).  It is the only exception.  This means that you cannot also add in a Cash Balance or Defined Benefit plan in the year of the termination of the SIMPLE.  If you were to convert a SIMPLE in 2024 to a 401(k) safe harbor plan, you must wait until 2025 to start a Cash Balance or Defined Benefit plan.  I know this is disappointing for some folks who didn’t realize the impact of the language change to the Code.  Sorry.  Blame Congress.  There is no legal basis for ‘backing out’ the SIMPLE contributions already made for this year, so do not try this way around the law.  Your client will just need to be patient.

Another key takeaway from the new exception is that the mid-year change only works if the replacement plan is a safe harbor 401(k) plan.  That means it can be a traditional safe harbor or a QACA, match or nonelective.  But it has to be a safe harbor plan.

Third, you have to time things correctly.  You are required to give a 30-day advance notice to participants for the termination of the SIMPLE.  You also have to give a safe harbor notice with special language 30 days in advance of the start of the safe harbor plan.  An example of a timeline then might look like this:

June 30 – Amend SIMPLE to terminate effective August 1 and create new safe harbor plan to be effective as of August 1

July 1 – Distribute SIMPLE termination notice and safe harbor notice

July 31 – SIMPLE contributions stop

August 1 – New safe harbor plan is effective, and contributions go to new plan

Fourth, the notice involves math.  For those of you who are not math-inclined, I’ll apologize in advance (but remember that it’s Congress’s fault, not mine).  In the safe harbor notice, the Employer is required to clarify what the deferral limit will be under the new safe harbor plan.  The deferral limit will need to be adjusted pro-rata based on the number of days each plan was in existence.  To really pickle your noodle, the language from section 332 requires that we calculate based on 365 days in a year.  Apparently, Congress doesn’t know we have leap years.

For example, using the timeline above, the SIMPLE will be in place for 213 days (January  through July 31).  The safe harbor will be in place for 153 days (August 1 through December 31).  (Yes, that’s 366 days because 2024 is a leap year.)  The pro-rata deferral limit under the SIMPLE plan would be the SIMPLE deferral maximum ($16,000) x (213/365) = $9,336.98.  The pro-rata deferral limit under the safe harbor plan would be $23,000 x (153/365) = $9,641.10.  Added together, the limit is $18,978.08.  But wait – there’s more.  Now, you have to subtract whatever the participant deferred under the SIMPLE.  Let’s say that’s $5,000.  So, for the safe harbor notice, I have to inform that participant that their limit is only $13,978.08 ($18,978.08 – $5,000).

In case you’re shaking your head, yes, you got it right.  To give the employee the information they need to properly plan their deferrals, you need to issue custom notices for the safe harbor plan with each participant’s personal deferral limit after subtraction of deferrals made to the SIMPLE.  After all, the deferral limit could be $13,987.08 for Mary, but $15,877 for Joe.   “Hang on!” you yell, “I have to give this notice out before I even know the total deferrals made under the SIMPLE!”  Yep.  That’s right.  Besides the fact that providing individualized notices is a burden unto itself, there is the timing aspect.  You’ll need to project what the participant will defer under the SIMPLE through that July 31 date from our example, issue the notice based on that, and if, for some reason, those figures change, you’ll need to update the numbers and issue a revised notice, advising them of the correct deferral limit.  If you choose not to provide the participant with the individualized information to properly determine their remaining deferral availability, you are asking for errors to be made.

Another concern that came to my mind was the challenge of getting payroll and the recordkeeper to track all of these different limits.  So, even if you don’t do the individualized limit calculations for the participants, someone needs to do so early in the 401(k) process to make sure that excess deferrals are caught.  Make sure you brush up on how to correct 402(g) failures, because you’re probably going to see these when you test the following year.  (Speaking of which – heaven forbid the Employer changes service providers mid-stream of the year of conversion, making sure the new provider has accurate data for reviewing the 402(g) limits should be fun.)

It is important to note that the IRS missed one key point in the Grab Bag guidance.  There is no clear guidance as to what we should do with catch-up contributions.  It is implied, and I think this is the conservative approach to take, that you will need to do the same pro-rata formula for calculating the permissible catch-up amount, and include that in the notices.

Lastly, under a SIMPLE plan, normally a participant with fewer than 2 years of participation would be ineligible to roll over any distribution to a qualified plan (rollovers to IRAs were permitted) and any distribution within that period would be subject to an increased 25% additional tax under Code section 72(t).  Under this change, as long as the SIMPLE rollover goes to a 401(k) or 403(b) plan and is subject to the usual distribution restrictions as other 401(k) deferrals, the 2-year limitation and special taxes do not apply.  So, if the employee chooses to move their money from the terminated SIMPLE to the new 401(k) plan, it will be subject to the same distribution restrictions as are 401(k) salary deferrals.  (But note, the distribution availability normally provided for rollovers may or may not include the 401(k)-type limits.  Therefore, you will likely need to have a separate rollover account for the former SIMPLE funds to make sure they are not prematurely paid to the participant.)

Roth Allowed in SIMPLE and SEP IRA

SECURE 2.0 Section 601 was to be effective as of January 1, 2023, so having the IRS provide guidance 11 ½ months later wasn’t helpful for those who wanted to take advantage of these rules right away.  Section 601 allows both Simplified Employee Pensions (“SEP”) IRA and SIMPLE IRAs to permit participants to make elections to make contributions as Roth Contributions.  This provision is similar to Secure 2.0 Section 604, which permits qualified plans to allow participants to have matching and profit sharing contributions contributed as Roth amounts.  Section 604 was effective as of the enactment date of SECURE 2.0; however, we are still waiting on guidance from the IRS as to how this should work in operation.  These provisions are a fundraiser for the government to help pay for some of the other provisions in SECURE 2.0 (i.e., as Roth amounts are after-tax contributions, they permit the IRS to get the tax revenue now, instead of later).

The election to allow employees to elect Roth contributions is optional, just like in a qualified plan.  For a SIMPLE IRA plan, if the employer permits Roth, it must provide employees the opportunity to contribute as Roth the same way as they elect to make pre-tax deferrals.  A SARSEP (for you new kids out there – that’s a pre-1997 SEP that allows employee to make pre-tax contributions, similar to a 401(k) plan), the same rules as the SIMPLE IRA apply.  For a SEP (no employee contribution), elections should be provided to participants to determine if they want the employer contributions funded as Roth.  All elections must be made before the relevant amounts are contributed to the arrangements.  The elections must be affirmative by the participants – that is, the SEP or SIMPLE cannot default to Roth contributions.

For tax purposes, the Grab Bag clarified that employee contributions are includable as income for the taxable year in which it would have otherwise been paid to the employee as compensation (e.g., if the employee Roth is made in 2024, it will be includable in 2024 income) and would be reported on Form W-2, Box 12.  The employee Roth contributions are subject to income tax withholding, FICA, and FUTA.

In contrast, employer contributions elected to be taken as Roth are includable for the taxable year in which the contribution was received (e.g., if the employer funds the 2024 nonelective in June 2025, it would then be income for the participant in 2025) and reported on a Form 1099-R in Boxes 1 and 2a.  The employer Roth contributions are not considered wages, and are, therefore, not subject to income tax withholding, FICA, or FUTA.

Good news for folks using the IRS model documents (Forms 5304-SIMPLE, 5305-SIMPLE, 5305-SEP, and 5305A-SARSEP): no amendments are needed until the IRS gets around to issuing updated models.  Any bets on when that will be?   Those not on the model will need to wait until the IRS has language in the Listings of Required Modifications.   So, for now, no amendments need to be made.

Changes to SIMPLE Contribution Limits

SECURE 2.0, Section 117 adjusted the contribution limits permitted under a SIMPLE plan.  The adjustments were to take place as of the first plan year starting on or after January 1, 2024.  Spoiler alert – because the Grab Bag guidance requires that the annual SIMPLE notice include special language if those limits are to be used, and the guidance wasn’t released until late in December 2023, after the annual SIMPLE notice distribution deadline, no one can take advantage of the higher limits until January 1, 2025.  (Good job, IRS.)  The increase would permit employee contributions and catch-up contributions that are 110% of the limit for calendar year 2024.  Example:  in 2024, the deferral limit is $16,000 and catch-up limit is $3,500.  The increase, if it could be used for 2024, would permit deferrals and catch-up of $17,600 and $3,850, respectively.

These higher limits are only available if the Employer, and all members of its controlled group, have not established or maintained a qualified plan under 401(a), 403(a), or 403(b) in the past 3 taxable years.   That rule applies to both SIMPLE 401(k) and SIMPLE IRA plans.

Good news for Employers with no more than 25 employees who received at least $5,000 in compensation in the preceding calendar year: the increase is automatic for SIMPLEs.  For those with more than 25 employees who received at least $5,000 in compensation in the preceding calendar year,  the Employer must make an election in the form of a formal written action to institute the bigger employer contributions.  (Note that there is a 2-year grace period for the employee count, so if an Employer goes from 24 to 26 employees one year, they can still enjoy the automatic increase.)

For Employers that don’t qualify for the automatic increase, in order to take advantage of the increased limits, the Employer must increase its contribution to either a matching contribution of 100% of deferrals up to 4% of compensation (an increase from the regular 3%) or a nonelective contribution of 3% of compensation (an increase from the regular 2%).

Here’s the frustrating part.  These increases have to be disclosed in the annual participant notice, which must be distributed by the November 1 preceding the plan for which the increase is effective.  So, issuing the Grab Bag guidance in late December 2023 meant that the increased limits could not be used by anyone in 2024.  The Employer taking advantage of the new limits also must notify its recordkeeper and payroll provider of the changes so they can properly institute and monitor the limits.

If you know you have a client that wants to take advantage of this for 2025, you can get the paperwork started now.  Once the election is made, it stays in place until revoked.  (Hey, I’m trying to find the rainbow here!)

And Now For Something Completely Different

This last point has nothing to do with the SIMPLE changes, but it is timely, and we are getting a lot of questions about this.  If you missed the IRS announcement on July 15, 2024, because of challenges with getting vendors authorized to submit Form 5330 electronically, it can still be filed on paper for 2023 and 2024.  So, you can take a breath.

Prior to the 2023 tax year, if you wanted to file an extension for Form 5330, you would use Form 5558.  For plans that routinely had testing failures that were never resolved prior to March 15, it was the practice for certain third-party administrators to file the extension while they waited for data to complete the annual work.

For plan years beginning in 2024 forward, the IRS has changed the rules.  Instead of using Form 5558 for the Form 5330 extension, plan sponsors need to file Form 8868 to extend the Form 5330.  In looking at Form 8868, and the new language and requirements, the IRS is requiring Employers to a) identify the total tax due, b) pay said tax, and c) write a small essay about why they can’t file the Form 5330.  If the TPA had completed the annual work, it would know the amount and would simply prepare and file the Form 5330.  This requirement for calculating and paying the taxes with the extension, while being consistent with IRS requirements for income tax forms, appears to render the Form 8868 useless on a practical basis.

In all likelihood, you will need to estimate the tax to file the Form 8868, include a statement that the form cannot be filed timely because there is still time to correct testing failures and the employer is taking that time, and then file the Form 5330 with either any additional tax or a request for refund.  This complication may make the extension useless from a practical standpoint.

Where does that leave practitioners?  Warn your clients that failure to get data in timely for annual work will lead to late filing of Form 5330, which will lead to additional fees for the interim calculations and extension form, possible penalties and interest if your estimates of the tax are too low, and a potential need to wait for a refund from the IRS if the interim tax calculation is too high.

In a rapidly changing world, there are always questions to be asked and problems to be solved.  FBLC is here to be your ERISA solution!