Written by True Tamplin, BSc, CEPF®
Updated on June 21, 2021
The Salary Reduction Simplified Employee Pension Plan (SARSEP) Plan refers to IRA plans established by small businesses before January 1997. No new SARSEP IRAs have been created since then. they were discontinued after passage of the Small Business Job Protection Act of 1996. SARSEP plans are similar to SIMPLE IRAs but were designed for small businesses with fewer than 100 employees. While they offer limited benefits, SARSEP plans are still used by some small businesses. Funds from SARSEP plans can be transferred to other retirement accounts without incurring taxes.
Basics of SARSEP Plans
Labeled as the “poor man’s 401(K)” when they were launched, SARSEP plans were created as part of the 1986 Tax Reform Act. They were an alternative to 401(K) plans and enabled small businesses to offer mini – 401(k) plans to employees. SARSEP IRAs had a similar structure and terms to regular 401(K) and were free to setup. But they failed to catch on with employers. Various reasons were put forward for their failure, from marketing failures to small business concerns about scaling the plans once their employee numbers went past 25. Eventually Congress replaced SARSEP with SIMPLE IRA, which was similar to SARSEP but had enlarged scope and flexibility. For example, it allowed small businesses of up to 100 employees to enroll in the program.
Small businesses can continue to maintain their SARSEP plans, provided they meet certain criteria. For example, they must have 25 or fewer employees in the preceding year. Second, at least 50% of the business’s employees must agree to contribute to the plan. A small business with a SARSEP plan in place can grandfather new employees into an existing plan. As with other retirement plans, employers must provide notifications of SARSEP plans to employees.
New employees are grandfathered into SARSEP plans. SARSEP IRAs are similar to SEP IRAs, which are also designed for small businesses. You can rollover funds from your SARSEP IRA accounts to other retirement accounts tax-free. However, only employer contribution is mandatory in a SEP IRA whereas SARSEP IRAs require contributions from employees as well as employers. Withdrawals from SARSEP plans are allowed after 59.5 years of age and premature withdrawals incur 10% penalty along with income tax. Required Minimum Distributions (RMDs) begin after the age of 72.
How to Setup a SARSEP IRAs
It is not possible to set up new SARSEP IRAs because they were discontinued after 1997.
Advantages and Disadvantages of SARSEP Plans
While it is not possible to create a new SARSEP Plan, they still offer some advantages for small businesses who might be interested in continuing to maintain them. For example, SARSEP plans offer tax benefits. They are tax-deferral financial instruments, meaning you do not need to pay taxes on income derived from the account. You will only pay tax when you begin withdrawing money after the age of 59.5 years. For small businesses that set up SARSEP accounts before 1996, such retirement accounts may also be cheaper to maintain as compared to a regular 401(K) or a SIMPLE IRA. The cost to establish a SARSEP account was practically nothing back in 1991 while 401(k)s cost upwards of $5,000. Shifting to a new retirement account may be an uneconomic decision for some small businesses, especially those with fewer than 25 employees.
Probably the biggest disadvantage of SARSEP plans is that they may not scale. So, if you already have a SARSEP IRA in place and grow beyond 25 employees, then you will have to opt for a new retirement account. SARSEP IRAs also have the same drawback as other IRAs, namely you cannot take out a loan against them. This is in contrast to 401(k)s, whose assets can be worthy of a loan.