Retirement Plans FAQs regarding SARSEPs
These frequently asked questions and answers provide general information and should not be cited as any type of legal authority. They provide the user with information responsive to general inquiries. Because these answers do not apply to every situation, yours may require additional research.
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Distributions, Loans and Investments: SEP-IRAs are the investment vehicles for SARSEPs. 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.
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 5305A-SEP 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, Form 5305-A, 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 5305A-SEP.
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:
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 2005, but 27 eligible employees in 2006, salary reduction contributions may be made to the SEP-IRAs of the 27 employees for 2006. However, in 2007 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:
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:
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, is used for this purpose.
Failure to furnish an annual statement showing the amount contributed subjects the employer to a $50 penalty per failure, unless the failure is due to reasonable cause.
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.
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:
Who is an eligible employee?
An eligible employee is an individual who meets the following requirements:
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 2012 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 2007 to 2011. Thus, an employee that worked for the employer in 2007, 2010 and 2011, must share in the SARSEP contribution made for 2012.
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.
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:
Compensation generally includes amounts deferred in the following employee benefit plans and arrangements. These amounts are elective deferrals:
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:
Compensation generally cannot include either of the following items:
How much may an employee defer under a SARSEP?
An employee may make an elective deferral up to the lesser of the following amounts:
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 $5,500 for 2012 and 2013 and subject to cost-of-living adjustments thereafter.
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.
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, $17,000 in 2012 and $17,500 in 2013 ($22,500 in 2012 and $23,000 in 2013 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 5305A-SEP 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 5305A-SEP for this computation.
What is the definition of a highly compensated employee?
A highly compensated employee is an individual who:
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 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 2012, and the employer provides notification on March 1, 2013, the excess SEP contributions must be withdrawn by April 15, 2013. If an employee withdraws excess SEP contributions (and earnings) from his or her SEP-IRA on April 1, 2013, the excess SEP contributions must be reported as taxable income for 2012. Earnings on the excess SEP contributions must be reported as taxable income for 2013.
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?
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 $250,000 for 2012 and $255,000 for 2013, subject to annual cost -of-living adjustments) or $50,000 for 2012 and $51,000 for 2013 (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 $250,000 for 2012 and $255,000 for 2013 and subject to annual cost -of-living adjustments for later years) paid to all the participants during the year. Elective deferrals made on behalf of 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 5305A-SEP and Pub 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:
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 1/2?
Contributions must be made for each eligible employee in a SARSEP, even if over age
Why is the 2012 contribution that was made in 2013 for the SEP-IRA shown on the 2013 Form 5498 and not on a 2012 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.
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?
Have a Question?
If I have questions concerning SARSEPs, where do I go for help?
You may direct your technical and procedural questions concerning retirement plans to TE/GE Customer Account Services at (877) 829-5500 (a toll-free number).
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See also our complete line of Forms and Pubs regarding retirement plans.
For other questions regarding retirement plans, visit our Frequently Asked Questions.