What Is a SARSEP

SARSEP plans are retirement savings accounts for small businesses with 25 or fewer employees. They are increasingly rare, however, because Congress prohibited them almost two decades ago. If your employer offers a SARSEP it’s only because plans set up before 1997 are still allowed as long as certain conditions are met.

With a SARSEP, you participate by choosing an amount of money that gets taken out of your paycheck before taxes and deposited into an investment account set up in your name. Employers cannot match your contributions, but they can contribute to a SARSEP on your behalf. The money in your SARSEP grows tax-free until you retire, at which point you’ll owe income taxes on the amounts you take out.

Do I Need a SARSEP Plan?

Only if it’s the only retirement savings plan available to you at work. After Congress discontinued SARSEPs, the IRS planned for SIMPLE IRAs to replace them. There are other workplace retirement programs, such as a 401(k), that may be available to you and that are easier to understand and manage. Keep in mind that you can still contribute to your personal retirement accounts, such as a traditional IRA or Roth IRA.

If you’re new to a job that offers SARSEPs, you’ll want to learn more; even though new SARSEPs are not allowed, existing ones can enroll new employees. If you work for a state or local government or a non-profit organization, stop reading. These types of employers were specifically prohibited from using SARSEPs.

How Does a SARSEP Plan Work?

SARSEPs can be complicated — for your employer. In their most simplest form, they work a lot like other defined contribution plans: First, you have to be eligible to participate, which in this case means you’re at least 21 years old and have worked at your employer for three of the last five years (the IRS calls this the "3-of-5 rule.").

Next, you choose whether to contribute to a SARSEP and how much money you’d like to divert before taxes are taken out. Your contributions are then deposited into a special account, called a SEP IRA, that’s been set up in your name.

SEP IRAs follow the same investment rules as traditional IRAs: your contributions, which are tax deductible, are invested and allowed to grow tax-free during your working years. The IRS limits how much you can defer to your SARSEP to $18,000 in 2015, or 25 percent of your compensation (whichever is less). Some plans, for example, allow you to invest an additional $6,000 into your SARSEP if you are at least 50 years old. This is called a "catch up" contribution and it’s intended to give older workers an extra financial boost.

Your employer’s contributions to a SARSEP won’t affect the amount you can contribute to your traditional IRA or Roth, but you may not be able to deduct from your taxes the amount you deposit into a traditional IRA.

When you reach 59 ½, you can take money out of your SARSEP. Any withdrawals you make will be taxed as ordinary income at your current marginal tax rate. Like with traditional IRAs, any money you take out of your SARSEP before you reach 59 ½ are subject to income tax plus a 10 percent penalty. The exceptions to this rule are similar to those in a traditional IRA.

Also, you can also roll over your contributions and earnings on your SARSEP account to IRAs and retirement plans without paying tax.

Small business owners have to pay close attention to the rules allowing them to keep their SARSEPs from one year to next. The IRS conditions are very specific and often complex:

  • To offer a SARSEP, an employer can’t have more than 25 employees who were eligible to participate the year before. This means, for example, that if your employer had 22 employees in 2014, it can participate in a SARSEP for 2015. But if your employer now has 30 employees, it won’t be able to participate in its SARSEP in 2016.

  • The "3-of-5 rule" applies when calculating which employees can participate in a SARSEP.

  • Your employer’s SARSEP must pass a "nondiscrimination test," which is similar to a traditional 401(k) plan. This basically ensures that all employees are treated fairly in the plan. Your employer has to do some math here, but it boils down to this: highly-paid workers found to contributing too much have to take money out of their accounts until the balance among employee contributions is restored.

  • Another fairness rule: employers can’t contribute more to accounts held by its top-paid workers. If more than 60 percent of its contributions are going to high earners, then your employer has to contribute to each lower paid employee’s account, up to a maximum of three percent of his or her salary.

There’s one more important rule for SARSEPs: at least half of your employer’s eligible workers have to contribute to the SARSEP each year. If less than half do so, then nobody can contribute to the SARSEP for the year. Any deferrals made have to be returned from the employees’ SEP IRAs.

How a SARSEP Can Help You Retire

If your employer offers a SARSEP, it may be the only workplace retirement savings plan that’s available to you. You should take advantage of it, keeping in mind that, from your perspective, a SARSEP works a lot like a 401(k). Remember, however, that if your employer has less than 25 employees in one year, you (and your co-workers) won’t be able to participate the following year since the plan basically freezes. That’s going to lower your eventual payout when you retire. For this reason, you’ll definitely also want to have an Individual Retirement Account, either a traditional IRA or a Roth IRA. You’ll probably need income from both your SARSEP and your IRA to complement your Social Security and any other retirement income you’ll need to live comfortably.

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