Chapter 4 — SARSEPs

In a regular SEP plan, the employer decides whether to make a contribution and how large that contribution will be. A Salary Reduction SEP (SARSEP) adds an employee elective deferral component: employees may choose to have the employer contribute a portion of their salary to their SEP-IRA account instead of receiving that amount as current compensation.

In this respect, SARSEPs function similarly to a 401(k) plan — allowing employees to defer income that would otherwise have been received and taxed currently. The deferred amount is not included in the employee’s taxable income for the year. Earnings in the SEP-IRA grow tax-deferred, and distributions are taxable as ordinary income when received.

Standard SEP rules apply to any employer contributions made in addition to the employee’s salary reduction. A SARSEP thus combines employee-initiated deferrals with optional employer contributions.

As of December 31, 1996, the tax code prohibits the establishment of new SARSEPs. Congress replaced them with SIMPLE plans (Savings Incentive Match Plans for Employees), which provide a simpler and more flexible alternative for small employers wanting to offer employee elective deferrals.

However, the law preserved grandfathered plans:

• Employers who established a SARSEP before January 1, 1997 may continue to maintain it and make contributions under pre-1997 rules.
• Employees hired after December 31, 1996 may still participate in a pre-1997 SARSEP — the prohibition applies only to establishing new plans, not to covering new employees in existing ones.

To maintain an existing SARSEP and allow employee deferrals, the following conditions must be met each year:

The employer must have had 25 or fewer eligible employees at any time during the prior calendar year. If the employer grows beyond 25 eligible employees in any year, the SARSEP is at risk of disqualification for that year’s deferrals.

At least 50% of all eligible employees must elect to make salary reduction contributions in order for the SARSEP to operate in a given year. If fewer than half of eligible employees choose to defer, the SARSEP fails this test and employee deferrals for that year may be disallowed.

This participation floor encourages broad employee adoption and helps prevent the plan from being used exclusively by owner-employees and highly compensated workers.

SARSEP elective deferrals must also pass an Actual Deferral Percentage (ADP) test similar to the one required for 401(k) plans. The ADP of eligible highly compensated employees may not exceed the ADP of non-highly compensated employees by more than the permitted differential. If the plan fails the ADP test, excess deferrals must be returned to the highly compensated employees.

SARSEP elective deferrals are subject to the standard annual elective deferral limit — the same limit that applies to 401(k), 403(b), and other plans allowing elective contributions. This limit is an aggregate across all such plans in which the employee participates.

The elective deferral limit applies only to the employee salary reduction portion of the SARSEP contribution. This limit may not exceed the lesser of $24,500 or 25% of the employee’s compensation. Any additional contributions made by the employer follow the standard SEP rules — up to 25% of compensation or $72,000 total (2026), with compensation capped at $360,000.

An employee who participates in a SARSEP and also defers into a 401(k), 403(b), or another SARSEP must count all elective deferrals toward the combined $24,500 limit. Excess deferrals across unrelated employers must be reported and included in the employee’s taxable income for the year.

Unlike regular employer SEP contributions (which are exempt from FICA and FUTA), SARSEP salary deferrals are subject to FICA (Social Security and Medicare) and FUTA (federal unemployment) taxes — because they originate from the employee’s wages. The employer must withhold and remit these employment taxes on SARSEP deferral amounts.