A Salary Reduction Simplified Employee Pension Plan (SARSEP) is a retirement plan that was originally available prior to 1997. It was a type of plan that allowed employees, through salary reductions, to make pretax contributions to individual retirement accounts (IRAs).
SARSEPs were mainly offered by smaller companies, however, are no longer available to employees following the Small Business Job Protection Act of 1996. You will now find that instead of SARSEPs, employees can contribute to 401(k) retirement plans.
How Does a SARSEP Work?
A SARSEP is a type of simplified employee pension (SEP) plan. They are no longer able to be established, as of 1997.
However, if a SARSEP was established prior to 1997, employees are still allowed to participate. Let’s review some of the basics of a SARSEP below.
Basic of SARSEP Plans
New SARSEP plans are no longer permitted. However, if an employer established a plan prior to year end 1996, they are able to add new employees to it.
SARSEPs were traditionally offered by smaller companies and offered pretax contributions through pay deductions.
History of SARSEP
Often featured as an employee benefit, SARSEPs would allow employees to make direct contributions from each pay into a tax-deductible retirement plan. Employers were also allowed to make additional contributions.
However, in 1996, President Bill Clinton signed into law the Small Business Job Protection Act of 1996. Once this piece of legislation was passed, no new SARSEPs were able to be created.
What Is the Maximum Contribution to a SARSEP?
The maximum contribution for 2020 and 2021 was $19,500 (for 2019 the amount was $19,000), or 25% of compensation. There is a catch up provision that allows employees aged 50 and older to additionally contribute $6,500 for 2020 and 2021 ($6,000 in 2019).
The 25% contribution applies to both employer and employee contributions and cannot exceed $58,000 for 2021, $57,000 for 2020, or $56,000 for 2019.
How Do You Terminate a SARSEP Plan?
An employer can terminate a SARSEP at any time. Once the SARSEP is terminated, an employer can stop funding it.
If an employer plans on terminating a plan, they should notify their employees, as well as the institution that is under contract or agreement with them. However, the IRS does not need to be notified of the termination.
Can a SARSEP Be Rolled Into an IRA?
The simple answer to this question is yes, a SARSEP can be rolled over into an IRA. Employees are able to roll over SARSEP contributions tax-free to other IRAs or retirement plans.
Employees are generally under the requirement to begin distributions by the age of 70 ½; however, if your 70th birthday falls on July 1, 2019 or later, you can wait on distributions until you are 72 years of age.
Requirements to Setup a SARSEP
In order to set up a SARSEP, there were two documents that were required to be completed by a company to the IRS. There needed to be a document outlining the SARSEP plan itself; either FORM 5305A-SEP or a comparable form.
There also needs to be a document for each employee that chose to participate in the plan. Of course, since SARSEPs are no longer able to be established, those that were previously initiated prior to 1997 may need to be amended for the most current law.
Could Any Employer Establish a SARSEP?
There were some conditions that may have prevented setting up a SARSEP plan for employees. They were not able to be established by a state or local government, any political subdivisions, agencies, or instrumentalities, or tax-exempt organizations.
If a company had previously established a SARSEP, they would need to maintain 25 employees or less in order to continue operating the plan.
Who Is an Eligible Employee?
Eligible employees must meet the following requirements:
- 21 years of age or older
- Worked for the employer for 3 or the last 5 years
- Received at least $650 salary for 2021 ($600 for 2019 and 2020)
Additionally, employees can be excluded from SARSEPs under two conditions:
- If they are covered by a union agreement, assuming the agreement was bargained for under good faith by the union and employer
- If they are a nonresident alien employee without U.S. wages, salaries, or other person services from the employer.
What Requirements Apply to Keep a SARSEP?
In order to maintain a SARSEP that was established prior to 1997, there are several requirements that must be met, including:
- At least 50% of eligible employees choose to make salary reduction contributions within the current year
- Any elective deferrals must meet the SARSEP deferral percentage limitation
- 25 or fewer employees eligible to participate in the preceding year
This rule is a “look-back” rule, meaning if a company had 28 employees in 2015 and 22 employees in 2016, the 28 employees from 2015 may make salary reduction contributions to their SEP-IRAs. That being said, employees in 2017 may not, because the employee number fell to 22 in 2016.
There have been several references to a simplified employee pension plan and individual retirement account (SEP-IRA), but what exactly is a SEP-IRA? It is a plan that replaced SARSEPs from 1997 on.
They are basic, tax deferred individual retirement accounts. SEP-IRAs can be established by an employer or someone who is self-employed, owns a business, or earns any type of freelance income.
SARSEP vs SEP
The key difference between a SARSEP and a SEP comes down to when they were initiated. Essentially, a SARSEP is a SEP that was established prior to 1997. Traditional SEP-IRAs have replaced SARSEPs.
Forms to File Under SARSEP
There are several forms that must be filed under a SARSEP. Let’s review these necessary forms below.
The Form 5500, while usually required by most qualified retirement plans, is not generally required for SARSEPs. They are exempt from the reporting and disclosure requirements usually required by the Department of Labor as long as the employer satisfies notice requirements and does not impose restrictions on investments contributed to an employees’ SEP-IRAs.
Reporting on W-2
When completing a W-2, employee elective deferrals must be included in the Social Security wages and Medicare wages tips boxes; however, they do not need to be included in the wages, tips, and other compensation box of a W-2. SARSEP wages must also be included in box 12 and box 13 must be checked.
Form 5498 must be completed by the trustee or issuer of a SEP-IRA to report contributions. It must be submitted to the IRS, including a separate form for each participant of a SARSEP.
A copy of the Form 5498 must be given to all participants to show account activity, as well as a statement of fair market value.
This form must be completed to report distributions from a SEP-IRA. They are subject to the same withholding requirements as a traditional IRA.
Do SARSEPS Have Anti-Discrimination Tests?
SARSEPs were given anti-discrimiation tests to try and equate distributions throughout a company. Essentially, they were put in place to make sure highly compensated employees (HCEs) were not receiving an unfair advantage or unfair percentage of contributions from the employer.
Two of these tests include the SARSEP DP test, which includes the deferral percentage (DP) limitation. Let’s review these below.
SARSEP DP Test
The SARSEP DP test includes the amount deferred each year by eligible HCEs. This value cannot be more than 125% of the DP of all eligible nonhighly compensated employees (NHCEs). This means that the amount that HCEs can defer is limited and based on the amount that NHCEs defer.
A deferral percentage is the ratio of an employee’s elective deferrals for any given year divided by their compensation for that same year. This must be calculated each year and must meet the SARSEP DP test. If an employer is unsure of how to calculate this, they can find instructions on the Form 5305A-SEP.
Should You Invest in a SARSEP?
Investing in a SARSEP will depend on whether or not your employer offers it as an option. You must be sure to meet all the qualifying criteria in order to participate.
Your employer may not offer a SARSEP depending on when they established their retirement programs. If you are unsure of the retirement options available to you by your employer, you can always consult with a financial advisor.
A financial advisor will be able to guide you through your retirement plan options. They can also help you to manage your accounts to help you make the most of your retirement.