IRS Offers Details on SECURE Act 2.0 Roth SEP and SIMPLE Provisions
By Mike Rahn, CISP
Given the many changes to the retirement landscape brought about by the SECURE 2.0 Act legislation, it would be difficult to identify any one provision that has the greatest potential to impact retirement savers. But, certainly, one strong candidate would be the new ability to make Roth contributions to simplified employee pension (SEP) and savings incentive match plans of small employers (SIMPLE) IRA retirement plans.
The popularity of a Roth option—with its potential for generating tax-free earnings—has been amply proven in the decades since Roth IRA contributions have been allowed, and since Roth salary deferrals have been permitted in 401(k), 403(b), and governmental 457(b) plans.
In terms of their federal tax impact, Roth-type contributions do not result in an immediate loss of tax revenue, as do retirement contributions that are tax-deductible or tax-deferred in the current year. However, when earnings resulting from Roth contributions ultimately achieve tax-free status, the result is a long-term loss of federal tax revenue.
SEP vs SIMPLE IRA
All contributions made under most SEP plans are employer contributions, the limited exception being those relatively few SEP plans that still permit salary reduction contributions—referred to as “SAR-SEP” plans—established before 1997, and whose continued operation is grandfathered. Consequently, new SEP plans are frequently established and operated by owner-only businesses without rank-and-file or common-law employees.
On the other hand, SIMPLE IRA plans are funded by employee and owner-employee salary deferrals in combination with employer matching or nonelective contributions. Consequently, these plans are favored by employers that do have rank-and-file employees, because less financial burden for plan funding falls on the employer.
Understanding SECURE 2.0 Changes
As with any legislation that makes significant changes to retirement savings arrangements, there is likely a period of time during which the industry must rely on the new statutes—and perhaps congressional committee notes—to understand and implement some of the changes. Eventually comes governing agency guidance, which hopefully adds clarity to the implementation of law changes. In the case of SECURE 2.0 legislation, the most complete guidance to date is IRS Notice 2024-02—issued in question-and-answer format—released on January 18, 2024.
What We Now Know
Following are some of the more significant clarifications in IRS Notice 2024-02 that pertain to SECURE Act 2.0’s Section 601, “SIMPLE and SEP Roth IRAs.”
The Roth Feature is Optional: Employers that sponsor a SIMPLE IRA or SEP retirement plan may, but are not required, to offer a Roth feature.
Timing of Roth Election: If the Roth feature is available in a SIMPLE IRA or SEP plan, the employer must offer an employee an “effective opportunity” to have contributions so treated, and—importantly—this election must be made before a contribution is made.
Employee Must Elect: An employer offering a Roth feature in a SIMPLE IRA or SEP plan may not make a Roth election for an employee. It must be affirmatively elected by the employee.
Tax Treatment for Employee: A Roth contribution to a SEP or SIMPLE IRA is included in gross income, rather than being tax-deferred, as it would be if it was non-Roth in nature. In the case of SIMPLE IRA (or SAR-SEP) salary deferrals, it is treated as gross income for the tax year the compensation would have been received, if not for the deferral election. All other SIMPLE IRA or SEP contributions are employer contributions and are includible in the employee’s gross income for the tax year in which the contributions are actually made, regardless of their treatment on the employer’s business tax return.
Reporting of Roth Salary Reduction Contributions: An employee’s Roth salary deferrals made to a SIMPLE IRA or SAR-SEP plan are reported on IRS Form W-2, Wage and Tax Statement, coded as appropriate to each plan type, and do not reduce employee gross income for the year.
Reporting of Employer Roth Contributions: According to IRS Notice 2024-02, employer contributions to a SIMPLE IRA or SEP plan are reported on IRS Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit Sharing Plans, Insurance Contracts, etc. The Form 1099-R is to be completed with the codes that are used for pre-tax IRA amounts being converted to Roth status: Code 2 for those under age 59½, Code 7 for those age 59½ or older. (IRS Notice 2024-02 identifies Form 1099-R as an employer responsibility, but in the IRA world in general, this function is typically fulfilled by a service provider.) Full taxability of the reported amount is to be assumed; meaning, no IRA basis is to be credited to the taxpayer, and thus no reduction in taxation. While this reporting approach may not have been anticipated—Form 1099-R is typically used to report retirement arrangement distributions, not contributions—it would appear that this approach will ensure that such employer contributions will be included in an employee’s taxable income.
IRS Form 5498, IRA Contribution Information, reports IRA, SEP, and SIMPLE IRA contributions. The form’s 2023 instructions indicate that if Roth SEP or SIMPLE contributions are made on an employee’s behalf, then—in addition to the contribution amount—two checkboxes within Box 7 are to be checked: both the SEP and the Roth IRA checkboxes in the case of Roth SEP contributions, or both the SIMPLE and Roth IRA checkboxes in the case of Roth SIMPLE contributions. In keeping with past Form 5498 reporting practice, both SIMPLE IRA employer contributions and employee salary deferrals are to be aggregated as a combined amount in Box 9. This would also be the case for Roth SEP arrangements (Box 8) where both employer contributions and SAR-SEP deferrals are made on behalf of the same employee.
Although not stated in the forms’ instructions, if both Roth and non-Roth contributions are made to either a SEP or SIMPLE IRA plan for the same employee, then it would be consistent with existing treatment of other types of contributions for two Forms 5498 to be filed to report these Roth and non-Roth amounts, with the appropriate checkboxes checked.
FICA and FUTA Withholding: Only salary deferrals that are made to a SIMPLE IRA or SAR-SEP plan will be subject to withholding for Federal Insurance Contributions Act (FICA, for Social Security benefit purposes) and Federal Unemployment Tax Act (FUTA, for unemployment benefits) purposes. Employer contributions to a SEP or SIMPLE IRA plan are not subject to FICA or FUTA withholding.
Use of Current SIMPLE and SEP Plan Documents: Until such time as the IRS issues new model SIMPLE or SEP plan documents, or other guidance—including document drafting language—employers that sponsor these retirement plans may operate their plans under the new statutory provisions that permit Roth contributions without executing an amendment to their IRS model, model-based, or IRS-approved SEP or SIMPLE IRA prototype document under which the plan is established.
More Guidance Needed
Given the broad scope of the SECURE 2.0 Act, IRS Notice 2024-02 understandably addressed many questions other than those pertaining to Roth SIMPLE IRA and Roth SEP arrangements. Following are several additional Roth issues that may need further IRS clarification.
Coordination of Roth SEP or SIMPLE Contributions with Roth IRA Contributions: One SECURE 2.0 Act statutory change has been interpreted as limiting Roth IRA contributions for those who have Roth SEP or SIMPLE IRA contributions made on their behalf. The IRS in Notice 2024-02 indicated that this apparently unintended consequence will be addressed in future guidance.
Roth vs Pre-Tax Contributions: It is not clear whether an election to have Roth contributions to a SEP or SIMPLE IRA is an all-or-nothing election. For example, can an employer—who makes the decision on whether to allow Roth contributions at all—permit, but place limits, on employee deferrals or employer contributions that will be Roth in nature? Or, can an employer allow Roth deferrals to a SIMPLE IRA or SEP plan, but require employer contributions to be pretax, or vice versa? Can an employee elect a portion of his SIMPLE IRA elective deferrals to be pre-tax, and the rest Roth?
Will There be New Employee-Level Roth Documents? IRS Notice 2024-02 indicates that employer Roth SEP and SIMPLE contributions will be reported as if they had been “made to an IRA that was not a Roth IRA and then immediately converted to a Roth IRA.” Does this mean that existing Roth IRAs will hold the new Roth SEP or SIMPLE Roth contributions? Or will new employee-level Roth SEP and Roth SIMPLE IRA documents be created by the IRS to hold them? The 2023 Instructions for Form 8606, Nondeductible IRAs, reference using the form to report “distributions from Roth, Roth SEP, or Roth SIMPLE IRAs.”
Will Roth “Ordering Rules” Be Affected? For determining potential tax impacts, Roth IRAs have well-understood ordering rules: all contributions in aggregate are distributed first, conversions next, earnings last. But Roth deferrals in SEP and SIMPLE IRA and SEP plans are to be treated as W-2 wages, while employer matching and nonelective contributions are treated for initial reporting purposes as Roth IRA conversions. Will Roth SIMPLE and SEP plan contributions be incorporated into the Roth IRA distribution ordering rules as we know them? Or what changes may be necessary?
Roth SEP and SIMPLE IRA Reporting Questions:
Will an early distribution penalty tax—if assessed—be done according to SEP or to SIMPLE IRA rules, which differ?
Because Roth SEP and Roth SIMPLE IRA employer contributions are reported as if “immediately converted to a Roth IRA,” will there be an early distribution penalty tax recapture period—generally five years for a Roth IRA—if a taxpayer under age 59 ½ withdraws such amounts? Early industry analysis suggests there is no such penalty recapture period.
Can Roth SIMPLE or SEP Contributions Be Made for 2024? It appears that Roth salary deferrals to an ongoing SIMPLE IRA or SAR-SEP plan may not be available for 2024 calendar-year plans (all SIMPLE IRA plans are calendar-year) due to timing requirements for employee notices and deferral elections. The availability of Roth contribution options for new SIMPLE IRA plans that begin midyear do not appear to be excluded, since such plans would have a midyear employee notification and deferral election period.
Roth employer SEP contributions can be made as late as an employer’s tax filing deadline, including extensions, but it is not clear from the SECURE 2.0 Act statutory language whether a required employee Roth election would have to be made during the plan year.
It is possible that the IRS could issue additional guidance on 2024 Roth SEP and SIMPLE IRA contribution implementation.
More to Come?
While definitely helpful, Notice 2024-02 is being viewed as just a beginning to the retirement industry’s understanding of the full impact of the SECURE 2.0 Act. More guidance on a number of this legislation’s provisions s eagerly awaited.
