SARSEP: The Salary Reduction SEP

Salary Reduction SEPs (SARSEPs) that were established by smaller businesses before 1997 may continue to be funded, and new employees may elect to participate in such plans, even if they were hired after December 31, 1996. However, new SARSEPs may not be established after 1996, having been replaced by the newly authorized SIMPLE (Savings Incentive Match Plan for Employees) retirement plans. The rules below remain applicable to pre-1997 SARSEPs protected by grandfather rules in the tax law.

Participation and Contributions

Employers with 25 or fewer employees who were eligible to participate at any time during the previous calendar year can maintain Salary Reduction SEPs. Under this plan, each eligible employee may elect either to have contributions made to the plan or have that amount paid to them in cash.

At least half of the eligible employees must elect to defer income to the plan.

SARSEP Deferral Amount

The salary reduction SEP arrangement is very similar to a 401(k) plan. SARSEP elective deferrals are not currently taxed to the employee. The salary reduction amount is limited to an annual maximum in accordance with the following table:

Technically, a plan may not permit additional catch-up contributions (elective deferrals) by persons age 50 and over for a particular year that are greater than the lesser of—

• the maximum incremental dollar amount allowable (i.e., $5,000 for 2008), or
• the excess of the individual's compensation for the year over other elective deferrals made for the year, ignoring the additional catch-up amount.

After 2006, the basic elective deferral limit and age-50+ catch-up amount are indexed to inflation in $500 increments, rounded down to the next lowest multiple of $500.

A plan is not required to allow additional "catch-up" contributions by participants age 50 and over; it is merely permitted to do so. A participant is deemed to be age 50 for a particular year if he or she turns 50 during that year.

Nondiscrimination Test

In a SARSEP the deferral percentage for each of the eligible "highly compensated employees" cannot exceed 125% of the average deferral percentage for all other eligible employees. The deferral percentage with respect to a particular employee is the amount of that employee's elective deferrals for the year, divided by the employee's total compensation for the year. Note that this is NOT the same as the nondiscrimination test for a 401(k) plan.

A highly compensated employee is defined as someone who—

• owns more than 5% of the employer's business, or
• receives compensation of more than $105,000 (for 2008, as indexed) and, if the employer so elects, is a member of the top-paid 20% group of employees.