Retirement plans FAQs regarding SARSEPs

 

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SARSEPs use SEP-IRAs as investment accounts. All SEP-IRAs are subject to the same investment rules as traditional IRAs. For more information on loans, distributions and investments in SARSEPs, please see our IRA FAQs.

These frequently asked questions and answers provide general information and should not be cited as legal authority.

General

What is a SARSEP?

A SARSEP is a simplified employee pension (SEP) plan set up before 1997 that includes a salary reduction arrangement. Under a SARSEP, employees can choose to have the employer contribute part of their pay to their Individual Retirement Account or Annuity (IRA) set up under the SARSEP (a SEP-IRA). A SARSEP may not be established after 1996. However, for SARSEPs set up before 1997, eligible employees hired after 1996 must be allowed to participate. See IRS Publication 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans) for detailed information.

Note: The IRS has a system of correction programs for sponsors of retirement plans, including SEPs and SARSEPs, which are intended to satisfy Internal Revenue Code requirements but have not met the requirements for a period of time. This system, the Employee Plans Compliance Resolution System (EPCRS), permits employers to correct plan failures and thereby continue to provide their employees with retirement benefits on a tax-favored basis. See Correcting Plan Errors for information on EPCRS.

What were the requirements to set up a SARSEP?

Establishing a SARSEP required two types of documents. The SARSEP plan itself and a SEP-IRA account for each employee participating in the SARSEP.

Generally, a SARSEP plan was established using either IRS Form 5305-A-SEP PDF or a prototype SARSEP that has been approved by the IRS. SEP-IRAs for each employee are set up with banks, insurance companies, or other qualified financial institutions using either IRS Form 5305 PDF, Form 5305-A PDF, or a prototype IRA approved by the IRS.

Although no new SARSEPs may be established, previously established SARSEPs may need to be amended for current law in order to maintain their tax-advantaged status.

How is a SARSEP amended for EGTRRA?

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) changed many of the Internal Revenue Code's requirements and limits for qualified plans and IRAs. If a model SARSEP plan was used, an updated model plan should have been adopted by the end of 2002 to take advantage of new law changes. See Form 5305-A-SEP PDF.

Could any employer establish a SARSEP?

No, SARSEPs could not be established by a state or local government, any of its political subdivisions, agencies, or instrumentalities or a tax-exempt organization.

Also, only employers with 25 or fewer eligible participants may continue to operate a SARSEP plan.

What are the requirements to maintain a SARSEP?

A SARSEP set up before 1997 must meet the following requirements each year:

  • 25 or fewer employees were eligible to participate in the SARSEP in the preceding year;
  • At least 50% of the eligible employees choose to make salary reduction contributions this year; and
  • The elective deferrals of highly compensated employees meet the SARSEP deferral percentage limitation.

If an employer has more than 25 eligible employees this year, but had less than 25 employees in the preceding year, may salary reduction contributions be made this year?

Yes, the 25-employee rule is a look-back rule. It is a year-by-year rule. For example, if an employer had 23 eligible employees in 2018, but 27 eligible employees in 2019, salary reduction contributions may be made to the SEP-IRAs of the 27 employees for 2019. However, in 2020 no salary reduction contributions may be made for the employees.

What happens if less than 50% of eligible employees make elective deferrals under the SARSEP?

If less than 50% of the eligible employees choose to make elective deferrals to the SARSEP for a year, all elective deferral contributions made by other eligible employees for that year are disallowed and must be withdrawn from the employees' SEP-IRAs. Each affected employee must be notified within 2½ months following the end of the plan year to which the disallowed deferrals relate (by March 15th of the following year for all model and other calendar-year SARSEPs), telling them:

  • the amount of the disallowed deferrals to their SEP-IRA for the preceding calendar year,
  • the calendar year in which the disallowed deferrals and earnings are includible in gross income,
  • information stating that the employee must withdraw the excess contributions (and earnings), and
  • an explanation of the tax consequences if the employee does not withdraw such amounts.

See the Instructions for Form 5305-A-SEP for a detailed description of correcting disallowed deferrals. This is a year-by-year rule. Each year the 50% rule is met elective deferral contributions for that year can remain in the employees' SEP-IRAs.

Are there any required notices to be given to employees/participants?

An employee must be given the following information within a reasonable time after the date the employee becomes employed:

  • Notice that the SARSEP is maintained,
  • Requirements an employee must meet to receive an employer contribution, and
  • The basis upon which the employer's contributions will be allocated.

This notification requirement can be satisfied by providing employees with a copy of the SARSEP agreement (Form 5305-A-SEP PDF), its instructions, and the other information listed in the Form 5305-A-SEP instructions if a model SARSEP has been adopted. If a prototype or individually designed SARSEP is used, similar information must be provided.

Failure to furnish the above information within a reasonable time subjects the employer to a $50 penalty per failure, unless the failure is due to reasonable cause.

In addition, each year an annual statement must be furnished to each employee participating in the SARSEP that shows the amount contributed to his or her SEP-IRA for that year. This annual reporting must be provided to the employee no later than the January 31 following the calendar year for which the report relates. Note: Often Form 5498, IRA Contribution Information PDF, is used for this purpose.

Failure to furnish an annual statement showing the amount contributed subjects the employer to a significant penalties, unless the failure is due to reasonable cause. See the Instructions for Forms 1099-R and 5498 PDF.

What forms must be filed under a SARSEP?

Form 5500: The Form 5500, Annual Return/Report of Employee Benefit Plan, that is required to be filed by most qualified retirement plans is generally not required for SARSEPs. SARSEPs are exempt from the Department of Labor's reporting and disclosure requirements provided the employer satisfies certain employee notice requirements and does not impose investment restrictions on monies contributed to employees' SEP-IRAs.

Reporting on Form W-2: Do not include employee elective deferrals in the Wages, tips, other compensation box of Form W-2. They must, however, be included in the Social security wages and Medicare wages and tips boxes. They must also be included in box 12. The Retirement plan box in box 13 must be checked. For more information, see the Form W-2 instructions PDF.

General Reporting Requirements: In addition to the employee notification requirements above, the bank, insurance company or other trustee or issuer of the SEP-IRAs must comply with the following general reporting requirements:

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Participation

Who is an eligible employee?

An eligible employee is an individual who meets the following requirements:

  • has attained age 21;
  • has worked for the employer in at least 3 of the last 5 years; and
  • has received at least $750 in compensation from the employer for the 2023 year ($650 for 2022 and 2021; $600 for 2020, subject to annual cost-of-living adjustments).

The employer may use less restrictive requirements to determine an eligible employee.

What is an example of the 3-of-5 rule?

Assume an employer has a SARSEP with a requirement that an employee must work for it in at least 3 of the last 5 years (the maximum requirement) to receive an allocation under the plan. To be eligible for the 2016 year, for example, an employee must have worked for the employer for some time (no matter how little) in any 3 years in the 5-year period 2011 to 2015. Thus, an employee that worked for the employer in 2011, 2012 and 2013, must share in the SARSEP contribution made for 2016.

Are there employees that may be excluded?

Yes, (a) employees covered by a union agreement whose retirement benefits were bargained for in good faith by the employees’ union and the employer; and (b) nonresident alien employees who have no U.S. source compensation from the employer may be excluded.

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Contributions

What is compensation for the purpose of determining contributions and elective deferral limits?

The definition of compensation can vary from plan to plan. The definition that must be used in operating the plan is defined in the plan's document.

For plan allocations, compensation is the pay a participant received from the employer for personal services for a year. The plan can generally define compensation as including all the following payments:

  • Wages and salaries;
  • Fees for professional services; and
  • Other amounts received (cash or non-cash) for personal services actually rendered by an employee, including, but not limited to, commissions and tips, fringe benefits and bonuses.

Compensation generally includes amounts deferred in the following employee benefit plans and arrangements. These amounts are elective deferrals:

  • qualified cash or deferred arrangement (section 401(k) plan);
  • salary reduction agreement to contribute to a tax-sheltered annuity (section 403(b) plan), a SIMPLE IRA plan or a SARSEP;
  • Section 457 nonqualified deferred compensation plan; and
  • Section 125 cafeteria plan.

However, if permitted under the plan document, an employer can choose to exclude elective deferrals under the above plans and arrangements (other than section 457 plans) from the definition of compensation.

Other options. In determining the compensation of a participant, the plan can treat any of the following amounts as the employee's compensation:

  • the employee's wages as defined for income tax withholding purposes,
  • the employee's wages reported in box 1 of Form W-2, Wage and Tax Statement, or
  • the employee's Social Security wages (including elective deferrals).

Compensation generally cannot include either of the following items:

  • Reimbursements or other expense allowances (unless paid under a non-accountable plan).
  • Deferred compensation (either amounts going in or amounts coming out) other than certain elective deferrals unless the plan does not include those elective deferrals in compensation.

How much may an employee defer under a SARSEP?

An employee may make an elective deferral up to the lesser of the following amounts:

  • 25% of compensation, or
  • $22,500 in 2023 ($20,500 in 2022; $19,500 in 2021 and 2020; $19,000 in 2019, subject to annual cost-of-living adjustments).

However, please note that the:

  • 25% of compensation applies to both employee and employer contributions and can’t exceed the annual limit of $66,000 for 2023; $61,000 for 2022; $58,000 for 2021; $57,000 for 2020 and $56,000 for 2019.
  • maximum employee compensation that may be considered for calculating the 25% of compensation is $330,000 for 2023 ($305,000 for 2022; $290,000 for 2021; $285,000 for 2020 and $280,000 for 2019).
  • $22,500 in 2023, $20,500 in 2022, $19,500 in 2021 and in 2020 ($19,000 in 2019) is the maximum elective deferral (pre-tax and designated Roth contributions) an employee may make for the year to a SARSEP, a SIMPLE IRA plan, a 401(k) plan or a 403(b) tax-sheltered annuity plan.

Can catch-up contributions be made to a SARSEP?

Yes, additional “catch-up” elective deferral contributions are allowed for employees who have reached age 50. Catch-up contributions are limited to $7,500 in 2023, $6,500 in 2022, in 2021 and in 2020 ($6,000 in 2019), subject to cost-of-living adjustments).

Can designated Roth contributions be made under a SARSEP?

No, designated Roth contributions cannot be made under a SARSEP.

What is considered compensation for a self-employed individual under a SARSEP?

Compensation of self-employed individuals. Self-employed individuals’ compensation is their earned income as defined below. Compensation does not include tax-free items (or deductions related to them) other than foreign earned income and housing cost amounts.

Earned income. Earned income is net earnings from self-employment from a business in which the self-employed individual’s services materially helped to produce the income. Earned income can also be from property the self-employed individual’s personal efforts helped create, such as royalties from books or inventions. Earned income includes net earnings from selling or otherwise disposing of the property, but it does not include capital gains. It includes income from licensing the use of property other than goodwill. Earned income includes amounts received for services by self-employed members of recognized religious sects opposed to social security benefits who are exempt from self-employment tax.

If the self-employed individual has more than one business, but only one has a retirement plan, only the earned income from that business is considered for that plan.

Refer to Publication 560, for additional information and helpful worksheets on the computation of self-employed compensation and plan contribution limits.

What happens if an employee defers more than the maximum dollar deferral limit?

If an employee defers more than the maximum limit of $22,500 in 2023 ($20,500 in 2022; $19,500 in 2021 and in 2020 and $19,000 in 2019), or $30,000 in 2023 ($27,000 in 2022; $26,000 in 2021 and in 2020; $25,000 in 2019) for a participant who is eligible to make catch-up contributions), he or she must withdraw the excess deferral amount and any associated earnings on this amount by April 15th following the calendar year to which the deferrals relate. The excess deferral amount taken out is included as additional taxable wages earned in the year originally deferred. Any income earned on the excess deferral taken out is taxable in the tax year in which it is taken out. These distributions taken timely by the April 15th deadline are not subject to the additional 10% tax on early distributions.

Deferrals not withdrawn by the April 15th date, though still treated as earned and taxable in the year originally deferred, will be included in income again in the year distributed and will be subject to the additional 10% tax. Furthermore, the excess deferrals will be subject to the traditional IRA limits and may be considered excess contributions to the employee's IRA. For the employee, these excess amounts may be subject to a 6% excise tax. See the Instructions for Form 5305-A-SEP PDF and Publication 560 for a detailed explanation.

Are there any other limitations on amounts an employee may defer?

Yes, the amount highly compensated employees may defer is subject to a deferral percentage limitation. This limitation is based on the amount nonhighly compensated employees defer. The deferral percentage limitation for highly compensated employees is computed by averaging the deferral percentages for the nonhighly compensated employees for the year and multiplying this result by 1.25. The deferral percentage limitation must be computed each year. See the Instructions for Form 5305-A-SEP PDF for this computation.

What is the definition of a highly compensated employee? (updated November 4, 2022)

A highly compensated employee is an individual who:

  • Owned more than 5% of the plan sponsor at any time during the year or the preceding year, or
  • For the preceding year, received compensation from the plan sponsor of more than $150,000 if the preceding was 2023; $135,000 if the preceding year was 2022; $130,000 if the preceding year was 2021 or 2020); subject to annual cost-of-living adjustments) and, if the SARSEP document so provides, was in the top 20% of employees when ranked by compensation.

What are the consequences if the deferral percentage limitation is exceeded?

Elective deferrals of highly compensated employees (HCEs) that are more than the amount permitted under the deferral percentage limitation are excess SEP contributions. Excess SEP contributions (and earnings) must be withdrawn from the employees’ SEP-IRAs. The employer must notify each HCE within 2 1/2 months after the end of the plan year of the following:

  • the amount of excess SEP contributions to his or her SEP-IRA for the preceding year,
  • the year the excess SEP contributions and earnings are includible in gross income,
  • that the employee must withdraw the excess contributions (and earnings) by April 15th following the calendar year of notification, and
  • the tax consequences if the employee does not withdraw such amounts.

See the Instructions for Form 5305-A-SEP PDF for detailed information on correcting excess SEP contributions for SARSEPs maintained on a calendar-year basis. If employees are not notified by 2 1/2 months after the end of the plan year of the excess contributions that must be withdrawn, the employer is subject to a 10-percent tax on these excess SEP contributions.

The excess SEP contributions are includible in the employees’ gross income in the year they were deferred. However, if an employee’s excess SEP contributions (not including earnings) are less than $100, they are includible in gross income in the year of notification. Earnings on excess SEP contributions are included in gross income in the year they are withdrawn from the employee’s SEP-IRA. For example, if excess SEP contributions occur in calendar year 2015, and the employer provides notification on March 1, 2016, the excess SEP contributions must be withdrawn by April 15, 2016. If an employee withdraws excess SEP contributions (and earnings) from his or her SEP-IRA on April 1, 2016, the excess SEP contributions must be reported as taxable income for 2016. Earnings on the excess SEP contributions must be reported as taxable income for 2016.

Excess SEP contributions not withdrawn by April 15th following the year of notification may be considered excess contributions to the employee’s IRA. Employees may be subject to a 6-percent excise tax on these excess contributions. In addition, if the employee is not 59 1/2 years of age or over, the employee may be subject to an additional 10-percent tax on early distributions.

May an employer contribute to the SARSEP for its employees? (updated November 4, 2022)

Yes, the employer may make non-elective contributions to the SEP-IRAs of its employees subject to an annual addition limit. The annual addition limit is the lesser of 100% of the employee's compensation (limited to $330,000 in 2023, $305,000 in 2022, $290,000 in 2021, $285,000 in 2020 and $280,000 in 2019, subject to annual cost-of-living adjustments) or $66,000 in 2023, $61,000 in 2022, $58,000 in 2021, $57,000 in 2020 and $56,000 in 2019, subject to annual cost-of-living adjustments). In determining this limit, all contributions made to the employee's SEP-IRA must be included: the amounts deferred by the employee and the non-elective contributions the employer made to the SEP-IRA. In addition, contributions made on behalf of an employee to another defined contribution plan the employer sponsors must be included in determining the annual addition limit. The same rule applies to contributions self-employed individuals make to their own SEP-IRA.

May an employer match an employee's elective deferrals?

No, matching contributions are not permitted in a SARSEP.

When must employee elective deferrals be deposited to each SEP-IRA?

Employee elective deferrals must be remitted to the appropriate financial institution as soon as possible but, in any event, no later than 15 days following the month in which the employee would have otherwise received the money.

When must employer contributions be deposited to each SEP-IRA?

Employer non-elective contributions must be made by the due date (including extensions) for filing the business's Federal income tax return for the year.

After SARSEP plan contributions are sent to the financial institution where the SEP-IRAs are maintained, that institution will invest the funds. SEP-IRAs can be invested in stocks, bonds, mutual funds, and similar types of investments.

How much of the contributions made to employee's SEP-IRAs may be deducted on the business's tax return?

The most that may be deducted on a business’s tax return for contributions to the employees' SEP-IRAs is the lesser of the contributions or 25% of the compensation (compensation for each employee is limited to $330,000 in 2023, $305,000 in 2022, $290,000 in 2021, $285,000 in 2020 and $280,000 in 2019, and subject to annual cost-of-living adjustments) paid to all the participants during the year. Elective deferrals made for the employees are not subject to the 25% of compensation limit. Self-employed individuals must make a special computation to figure out their maximum deduction for these contributions. When figuring the deduction for contributions made to the SEP-IRA, compensation is net earnings from self-employment which takes into account the following deductions; (a) the deduction for one-half of self-employment tax and (b) the deduction for contributions to the SEP-IRA. See the Instructions to Form 5305-A-SEP PDF and Publication 560 for details on determining this deduction.

Where do sole proprietors report employee elective deferrals made on their own behalf to their own SEP-IRA on their tax return?

Sole proprietors and partners deduct all contributions for themselves (including their own employee elective deferrals) on Form 1040, U.S. Individual Income Tax Return.

What is a top-heavy defined contribution plan and how does it apply to a SARSEP?

A SARSEP is top-heavy for a year when more than 60 percent of all employer contributions, including employee elective deferrals, go to key employees as determined at the end of the preceding year. But since many SARSEPs are always top-heavy, SARSEPs are often drafted to operate as if they were always top-heavy, thereby eliminating the need to make the annual 60 percent determination.

Top-heavy plans are subject to additional requirements. The employer will satisfy the top-heavy requirements by making a minimum contribution each year to the SEP-IRA of each employee eligible to participate in the SARSEP. This minimum contribution is not required for key employees. This contribution, in combination with other non-elective contributions, is equal to the lesser of:

  • 3 percent of each eligible non-key employee's compensation, or
  • the percentage of compensation at which elective (not including catch-up elective deferral contributions) and non-elective contributions are made under this SARSEP (and any other SEP maintained by the employer) for the year for the key employee with the highest percentage for the year.

For purposes of determining the top-heavy minimum contribution, all employee elective deferrals made by key employees must be counted, but no employee elective deferrals made by non-key employees are counted toward satisfying the minimum contribution.

A key employee is any employee who, at any time during the preceding year was:

  • An officer of the employer with compensation greater than $215,000 for 2023; $200,000 for 2022;$185,000 for 2021 and for 2020; and $180,000 in 2019 (subject to annual cost-of-living adjustments);
  • A 5 percent owner of the employer, as defined in IRC section 416(i)(1)(B)(i); or
  • A 1 percent owner of the employer with compensation greater than $150,000.

If a SARSEP fails to meet the SARSEP requirements are the tax benefits for the employer and employees lost?

Generally, tax benefits are lost if the SARSEP fails to satisfy the Internal Revenue Code requirements. However, the employer can retain the tax benefits if it uses one of the IRS correction programs to correct a failure. In general, when correcting a failure under the program, the correction should put employees in the position they would have been had the failure not occurred.

Can a contribution be made to a SEP-IRA of a participant over age 70 ½?

Contributions must be made for each eligible employee in a SARSEP, even if over age 70 ½. Such an employee must take minimum distributions, however.

Why is the 2015 contribution that was made in 2016 for the SEP-IRA shown on the 2016 Form 5498 and not on a 2015 Form 5498?

The IRS requires that contributions to a SEP-IRA be reported on the Form 5498 for the year they are actually deposited to the account, regardless of the year for which they are made.

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Termination of plan

Does a SARSEP have to be amended for the new law before it terminates?

Generally, the IRS has not required SARSEPs to be amended for new law prior to termination. Check with your plan professional.

Does a SARSEP have to be funded in the year of termination?

SARSEPs can be terminated at any time. The employer can stop funding these plans once they are terminated.

What are the notification requirements to participants, etc., when a SARSEP terminates?

When terminating a SARSEP plan, it is a good idea to notify the employees that the plan has been discontinued. The financial institution that was chosen to handle the plan may need to be notified that there will be no more contributions. The employer may also need to let the institution know that it will terminate the contract or agreement with it. The IRS should not be notified of the plan's termination.

If the employer goes out of business or the employee terminates service, can the amount in the SEP-IRA be left untouched?

Yes.

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Have a question?

If I have questions concerning SARSEPs, where do I go for help?

We regret that we cannot answer technical questions. If you have account-specific questions, see EP Customer Account Services. Also see our complete line of forms and publications regarding retirement plans.

For other questions regarding retirement plans, visit our frequently asked questions.

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Page Last Reviewed or Updated: 31-Jul-2024