Roll Over an Unnecessarily Complicated SIMPLE IRA

My wife mentioned to her friends that I know a thing or two about personal finance and investing. One of her friends — I’ll call him Jake (not his real name) — changed jobs recently. He asked me to look at his retirement plan account from his previous employer.

I asked Jake what type of account it was. He didn’t know. He thought it was a Roth IRA but I told him an employer plan wouldn’t be a Roth IRA because a Roth IRA is a personal account. He sent me a recent statement, which shows it’s a SIMPLE IRA.

Lower Contribution Limits

A SIMPLE IRA is an oddball in workplace retirement plans. It can only be offered by a small employer with no more than 100 employees. The employer sets up a SIMPLE IRA plan and each employee sets up a SIMPLE IRA under the plan.

Both the employee and the employer contribute to the account, as they do in a 401(k) plan. The annual contribution limit is lower. The employee contribution limit in a SIMPLE IRA is about 30% less than the employee contribution limit in a 401(k). The age-50+ catch-up contribution limit is less than half of the same limit in a 401(k). Don’t ask me why.

SECURE Act 2.0 raised the SIMPLE IRA contribution limit by 10% for employers with 25 or fewer employees. Employers with 26-100 employees can also have the higher contribution limit if they increase their match or non-elective contributions.

There was no Roth version of SIMPLE IRA before 2023. All contributions before 2023 were pre-tax. SECURE Act 2.0 authorized Roth SIMPLE IRA starting in 2023 but it’s optional. Each employer’s plan must allow it before employees can choose the Roth option. Most brokers haven’t updated their plans to allow it yet. For example, both Fidelity’s and Schwab’s SIMPLE IRA plans still only allow pre-tax contributions. As a result, most employers haven’t been able to update their SIMPLE IRA plans to add the Roth option yet.

Expensive Broker

The employer usually sets up a SIMPLE IRA plan with a broker. It’s helpful if the employer knows better to set up the SIMPLE IRA plan with a mainstream broker such as Fidelity or Charles Schwab but many small employers are sold the SIMPLE IRA plan by an expensive full-service broker.

The SIMPLE IRA plan is an employer-sponsored plan but the SIMPLE IRA accounts under the plan are technically personal accounts. Unlike a 401(k), a SIMPLE IRA plan doesn’t offer a menu of investment options. Each employee can invest in anything they want in the SIMPLE IRA. The full-service broker can charge loads and/or asset management fees in the SIMPLE IRA.

In theory, an employee can open a SIMPLE IRA at any financial institution of their choice under some SIMPLE IRA plans (“5304 SIMPLE”). In practice, employees don’t know they have this choice. The employer also discourages setting up accounts elsewhere because they want to send payroll contributions to only one place. It’s next to impossible for an employee to open a SIMPLE IRA at a different broker without the employer’s participation. As a result, employees go with the flow and use the broker chosen by the employer.

Jake’s SIMPLE IRA was like that. His former employer had a full-service broker “help” all the employees with investments in their SIMPLE IRA. The broker put three actively managed mutual funds in his account. Those funds were C shares with an expense ratio of 1.4% – 1.9% plus a backend load of 1% on shares sold within 12 months.

Escape Hatch After Two Years

One upside of a SIMPLE IRA is that it has an escape hatch after two years. Unlike a 401(k) account, which has to stay with the employer’s plan until the employee terminates employment or reaches age 59-1/2, an active employee can roll over the SIMPLE IRA after participating in the SIMPLE IRA plan for two years.

If you have a bad SIMPLE IRA with an expensive broker, you can transfer it to a Traditional IRA after bearing it for two years. New contributions will still go into the SIMPLE IRA but you can roll over the existing money to a Traditional IRA for lower fees and keep rolling over once a year or however frequently you prefer. The broker that has your SIMPLE IRA may charge a transfer-out fee for each transfer.

You’re stuck if you’re still within the first two years. Even if you already terminated employment, a SIMPLE IRA can only roll over to another SIMPLE IRA in the first two years. In theory, you can set up a SIMPLE IRA elsewhere to accept the rollover. In practice, it’s difficult to find a broker to set up a SIMPLE IRA on your own without an employer.

Rollover to Traditional IRA

Fortunately, Jake already had the SIMPLE IRA for longer than two years. I called both Fidelity and Schwab to confirm that they could accept the existing C shares mutual funds in his SIMPLE IRA and they wouldn’t charge a commission to sell those funds. I told Jake he could open a Traditional IRA with either Fidelity or Schwab and submit a Transfer of Assets request through the new account. He chose Fidelity. The shares came over after a week. The broker for the SIMPLE IRA charged him $125 for the transfer.

I suggested waiting until the purchase history came over through the ACATS transfer before selling those expensive actively managed funds. This reduced the backend load charged by the funds because the backend load doesn’t apply to older shares. I also suggested buying a Fidelity Freedom Index Fund with the proceeds. Fidelity didn’t charge a fee for selling the expensive funds or buying the target date index fund. The expense ratio of the Fidelity Freedom Index Fund is 0.12%, which is less than 1/10th of the expense ratio of those old funds. I showed Jake how to turn on dividend reinvestment.

Jake is happy when it’s all done. I’m happy I was able to help him. The rollover was unnecessarily complicated because his SIMPLE IRA was with an expensive broker. His former employer didn’t know better. He had no choice but to go with whatever the employer had set up. Jake is in his twenties. Getting a retirement account out of the hands of an expensive broker at an early age will have a positive impact on his retirement.

If you’re reading this blog, you know more about these subjects than people in your circles. Young people working for small employers especially tend to have bad retirement plans. Let them know you have this knowledge. Help them when they ask. It’s rewarding to set a young person on the right track.