Taxation IRAs 401Ks and the IRS

Simple IRA and Qualified Plans
1. A simple IRA has both advantages and disadvantages when compared to a qualified plan like a 401K. Both are tax-deferred savings accounts, but where the differences lay could matter for a company like 3P. These two types of plan are mutually exclusive – an employer cannot have both at the same time (Appleby, 2019).
However, with a simple 401K the employer could have another plan for employees who aren’t covered by the 401K, which would typically be employees who earn less than $5000 per year. This may not apply to very many people, but could theoretically be one of the differences between the two types of retirement plan. Employees under 21 or who have worked for less than a year may or may not be covered, but there is no age requirement for a simple IRA. If the company has a lot of younger workers, then it might want to opt for the simple IRA over the simple 401K, whereas for other companies there might not be much difference at all.
For either of these plans, the employer cannot have more than 100 employees, as both types of simple plan are built for small business that might struggle with the more complex regular 401K plan. But one of the biggest differences is whether loans are allowed. In a simple 401K, loans are allowed and in a simple IRA they are not. The merits of an employee being able to borrow from their retirement assets can be debated, but the 401K provides that option for employees. One of the biggest issues that an employee might face is a major health care bill, so in part the employer’s health care coverage, if any, might prove to be a contributing factor in this decision.
There are also differences in employer contributions. In a simple 401K, employer contributions are capped at $285,000, but only non-elective employer contributions to simple IRAs are subject to the compensation cap. If elective contributions are not subject to a cap, that probably benefits the highly compensated employees, which could of course include Paula and Prescott.
All told, these two plans are fairly similar for most people, but the differences can affect those at the high and low ends of the income spectrum. Younger workers will appreciate the lack of age limits on the simple IRA, and the owners/executives might as well. However, if Paula and Prescott do not believe they will want to make contributions above the limit, and may not have many workers under the age of 21, then the simple 401K might make more sense because it would allow them to offer a plan that has the ability to take loans, something that might appeal to employees who are looking to buy homes or who have sudden high medical bills and need to avail themselves of that option.
2. Workers who contribute to an employer-sponsored retirement savings plan can still contribute to their own plan as well. Philip, the 55-year-old employee of 3P, can make regular 401K contributions of $7000, a number that in part takes into account his age. This contribution is a total limit for all traditional and Roth IRAs, but does not include the employer-sponsored Simple IRA plan that he might be getting from 3P (IRS.gov, 2020).
The rules on deductions in this scenario are different. Philip may be able to deduct these contributions, but being covered at work would reduce the changes that the personal plan contributions would be deductible. This would depend on his income level. Another factor that the IRS will take into account is whether or not Philip is married and if so whether his spouse is also receiving some retirement plan coverage at work. The issue of deductibility cannot be determined, given that the information in the case does not provide answers to questions about his income, the amount of his work coverage, his marital status or the coverage status of his spouse.
3. Roth IRAs come with annual contribution limits that the IRS spells out on its website. Contributions limits are for combined traditional and Roth IRAs, and are $6000 for workers under 50 and $7000 for workers above the age of 50.
The contribution limits for the employer-sponsored Simple IRA are $285,000 for non-elective contributions, but there is no limit on elective contributions for the employer-sponsored plan. The deductibility for the traditional IRA depends on how much money the worker makes, if that worker is married and if so if they are filing jointly or not. The following table highlights what the deductibility would be under scenario:
Filing Status
Modified AGI
Deduction
Single or head household
$65,000 or less
Full deduction
Single or head household
$65,000 - $75,000
Partial deduction
Single or head househould
$75,000 or more
No deduction
Married, filing jointly
$104,000 or less
Full deduction
Married, filing jointly
$104,000 -$124,000
Partial deduction
Married, filing jointly
Over $124,000
No deduction
Married, filing separately
Less than $10,000
Partial deduction
Married, filing separately
Over $10,000
No deduction
The phase-out levels are the levels listed where there are partial deductions allowed.
4. According to the IRS, one normally has to “pay income tax on any amount you withdraw from your simple IRA.” If Pete is under the age of 59 ½ he would likely also need to pay an additional tax of 10% or 25% on the amount that he withdraws. Given that he has only been in this plan for 1.5 years, he would be hit with the 25% rate.
There are some exceptions to these taxes, one of which is qualified higher education expenses. Qualified education expenses must be paid by a dependent that the person claims on their return, which it appears is the case in this situation. The expenses must be for tuition, fees, books that are required for attendance at an eligible education institution. Furthermore, the expenses must be paid either in that tax year or within the first three months of the next tax year.
Without knowing the particulars beyond what’s in the question, it would appear that Pete will not pay additional taxes if the withdrawal from the simple IRA is used at an eligible education institution, specifically for expenses that are a necessary part of the program his daughter is taking, and that his daughter is listed as a dependent on his taxes.
References
Appleby, D. (2019) Simple IRA vs Simple 401K: What’s the difference? Investopedia. Retrieved April 2, 2020 from https://www.investopedia.com/articles/retirement/04/060904.asp
IRS.gov (2020) Retirement topics – IRA contribution limits. Internal Revenue Service. Retrieved April 2, 2020 from https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits
IRS.gov (2020) Contribution and deduction limits. Internal Revenue Service. Retrieved April 2, 2020 from https://www.irs.gov/retirement-plans/plan-participant-employee/2020-ira-contribution-and-deduction-limits-effect-of-modified-agi-on-deductible-contributions-if-you-are-covered-by-a-retirement-plan-at-work