SECURE 2.0 Clears Path for a SIMPLE IRA-to-Safe Harbor 401(k) Switch

Small business clients often choose a retirement plan based on conditions that exist in the early stages of the business’ existence. Starting a business can be time-consuming and stressful, which often means that ease of administration and lower costs become a deciding factor for business owners who adopt retirement plans when a business is young. While choices made by these small business owners may initially fit, conditions change over the life of a business. Business owners who adopted SIMPLE IRAs may later find that switching to a safe harbor 401(k) can have many benefits—especially when they’re trying to attract employees who have become accustomed to the standard 401(k) savings option. Fortunately, the SECURE Act 2.0 has now made it easier to make the switch starting in 2024. That means many business clients may have new questions about the differences between SIMPLE IRAs and safe harbor 401(k)s, as well as the technical rules for transitioning from a SIMPLE plan to a 401(k).

Making the Switch from SIMPLE-to-Safe Harbor Post-SECURE 2.0

Prior to the SECURE Act 2.0, business owners couldn’t change from a SIMPLE IRA to a 401(k) before the end of the year. By November 2, the employer was required to provide notice of the switch to employees. The formal termination date was always December 31, and the 401(k) start date was January 1.

This is important, because one of the rules governing SIMPLE IRAs says that the business owner cannot maintain any other retirement plan if they choose the SIMPLE IRA option.

SECURE 2.0 relaxed the rules so that employers can terminate a SIMPLE IRA mid-year and replace it with a safe harbor 401(k). When an employer replaces a SIMPLE plan with a safe harbor 401(k) mid-year, SECURE 2.0 simply created an exception to the general rule that an employer cannot maintain plans in addition to the SIMPLE IRA.

Pursuant to IRS guidance issued in December, the employer must take formal written action and specify the termination date. Employees must be given a 30-day notice before the termination date. The notice must tell them that no salary reductions to the SIMPLE IRA will be made based on compensation paid after the termination date. The employer must make matching contributions attributable to employee compensation earned through the termination date.

During the year of transition, the total amount contributed as salary reduction contributions under the terminated SIMPLE IRA plan and as elective contributions under the safe harbor section 401(k) plan cannot exceed the weighted average of the salary reduction contribution and elective contribution limits for each of those plans (based on how many of the 365 days in the transition year each plan was in effect).

SIMPLE vs. Safe Harbor: Issues to Consider

Initially, SIMPLE plans are only available to businesses with fewer than 100 employees who earned at least $5,000 in compensation.

The contribution limits that apply to 401(k)s are higher than those applicable to SIMPLE IRAs (in 2024, the 401(k) limit is $23,000 with a $7,500 catch-up option in 2024 vs. $16,000 with a $3,000 catch-up option for SIMPLE IRAs).

With a 401(k) safe harbor plan, the plan must receive 100% vested employer contributions in the form of either nonelective contributions equal to 3% of compensation (regardless of whether the employee chooses to contribute). In the alternative, the employer can elect to make matching contributions of 100% on the first 3% of compensation and 50% on the next 2% of compensation (the 4% match option). When compared to a traditional 401(k), however, the safe harbor 401(k) offers lower administrative costs.

Employers must also make mandatory contributions to SIMPLE IRAs each year (either a 100% match of 3% of the employee’s contributions or a 2% non-elective contribution).

Before enactment of SECURE 2.0, participants in SIMPLE IRAs could not roll amounts over contributed to the SIMPLE IRA for the first two years of participation. When the employer replaces the SIMPLE plan with a safe harbor 401(k), the amounts can be immediately rolled over to the replacement plan so long as that plan is subject to the same distribution restrictions that apply to 401(k)s (i.e., age 59 ½, death, separation from service, hardship, etc.).

Conclusion

Safe harbor 401(k)s can provide many benefits that the SIMPLE IRA option simply doesn’t offer. Higher contribution limits alone can be powerful when attracting and retaining employees. Now that making the transition has become easier, many employers may wish to evaluate the safe harbor 401(k) option going forward.

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