Salary Reduction Simplified Employee Pension (SARSEP)

A SARSEP is a SEP set up before 1997 that includes a salary reduction arrangement. (See the Caution, next). Under a SARSEP, your employees can choose to have you contribute part of their pay to their SEP-IRAs rather than receive it in cash. This contribution is called an "elective deferral" because employees choose (elect) to set aside the money, and they defer the tax on the money until it is distributed to them.

You are not allowed to set up a SARSEP after 1996. However, participants (including employees hired after 1996) in a SARSEP set up before 1997 can continue to have you contribute part of their pay to the plan. If you are interested in setting up a retirement plan that includes a salary reduction arrangement, see chapter 3.

Who can have a SARSEP? A SARSEP set up before 1997 is available to you and your eligible employees only if all the following requirements are met.

• At least 50% of your employees eligible to participate choose the salary reduction arrangement.
• You have 25 or fewer employees who were eligible to participate in the SEP (or would have been eligible to participate if you had maintained a SEP) at any time during the preceding year.
• The elective deferrals of your highly compensated employees meet the SARSEP ADP test.

SARSEP ADP test. Under the SARSEP ADP test, the amount deferred each year by each eligible highly compensated employee as a percentage of pay (the deferral percentage) cannot be more than 125% of the average deferral percentage (ADP) of all non-highly compensated employees eligible to participate. A highly compensated employee is defined in chapter 1.

Deferral percentage. The deferral percentage for an employee for a year is figured as follows.

The instructions for Form 5305A-SEP have a worksheet you can use to determine whether the elective deferrals of your highly compensated employees meet the SARSEP ADP test.

Who cannot have a SARSEP? A state or local government, any of its political subdivisions, agencies, or instrumentalities, or a tax-exempt organization cannot have a SEP that includes a salary reduction arrangement.

Limit on Elective Deferrals

The most a participant can choose to defer for calendar year 2001 is the lesser of the following amounts.

1. 15% of the participant's compensation (limited to $170,000 of the participant's compensation).
2. $10,500.

In 2002, the compensation limit in (1) increases to $200,000. The amount in (2) increases to $11,000 and participants who are age 50 or over can make a catch-up contribution of up to $1,000.

The $10,500 limit applies to the total elective deferrals the employee makes for the year to a SEP and any of the following.

• Cash or deferred arrangement (section 401(k) plan).
• Salary reduction arrangement under a tax-sheltered annuity plan (section 403(b) plan).
• SIMPLE IRA plan.

Overall limit on SEP contributions. If you also make nonelective contributions to a SEP-IRA, the total of the nonelective and elective contributions to that SEP-IRA cannot exceed the lesser of 15% of the employee's compensation or $35,000 ($40,000 for 2002). The same rule applies to contributions you make to your own SEP-IRA. See Contribution Limits, earlier.

Employee compensation. For figuring the elective deferral, compensation is generally the amount you pay to the employee for the year. Compensation includes the elective deferral and other amounts deferred in certain employee benefit plans. See Compensation in chapter 1. These amounts are included in figuring your employees' total contributions even though they are not included in the income of your employees for income tax purposes.

You can choose not to treat the deferral as compensation, as discussed later.

To figure the deferral, multiply the employee's compensation by the deferral contribution rate. However, you must always use the reduced rate method to determine the maximum deductible contribution (13.0435% of unreduced compensation). This is the same method you use to figure your deduction for contributions you make to your own SEP-IRA.

Example 1. Jim's SARSEP calls for a deferral contribution rate of 10% of his salary. Jim's salary for the year is $30,000 (before reduction for the deferral). You multiply Jim's salary by 10% to get his deferral of $3,000. Your maximum deduction for elective deferrals and any nonelective contributions would be $3,913.05 ($30,000 × .130435).

On Jim's Form W-2, you show his total wages as $27,000 ($30,000 - $3,000). Social security wages and Medicare wages will each be $30,000. Jim will report $27,000 as wages on his individual income tax return.

Choice not to treat deferrals as compensation. You can choose not to treat elective deferrals (and other amounts deferred in certain employee benefit plans) for a year as compensation under your SARSEP. You can use this method for calculating deferral percentages for the SARSEP ADP test defined earlier.

The deferral and the compensation (minus the deferral) depend on each other. For this reason, you figure the deferral indirectly by reducing the contribution rate for deferrals called for under the salary reduction arrangement. This method is the same one you use to figure your deduction for contributions you make to your own SEP-IRA. You must also use the reduced rate method to determine the maximum deductible contribution (13.0435% of unreduced compensation).

To figure the deferral, use either the rate table or rate worksheet in chapter 5. Use the rate table if the deferral contribution rate called for under the SARSEP equals a whole percentage. Otherwise, use the rate worksheet. When using the rate table, first locate the deferral contribution rate in Column A. Then read across to find the reduced rate in Column B. Multiply the reduced rate by your employee's compensation to get the deferral.

Example 2. The facts are the same as in Example 1 except you chose not to treat deferrals as compensation under the arrangement. To figure the deferral, you multiply Jim's salary of $30,000 by 0.090909 (the reduced rate equivalent of 10%) to get the deferral of $2,727.27. Your maximum deduction for elective deferrals and any nonelective contributions would be $3,913.05 ($30,000 × .130435).

On Jim's Form W-2, you show his total wages as $27,272.73 ($30,000 - $2,727.27). Social security wages and Medicare wages will each be $30,000. Jim will report $27,272.73 as wages on his individual income tax return.

Alternative definitions of compensation. In addition to the general definition of compensation in chapter 1 and the choice described in the preceding paragraphs, you can use any definition of compensation that meets all the following conditions.

• It is reasonable.
• It is not designed to favor highly compensated employees.
• It provides that the average percentage of total compensation used for highly compensated employees as a group for the year is not more than minimally higher than the average percentage of total compensation used for all other employees as a group.

Compensation of self-employed individuals. If you are self-employed, compensation is your net earnings from self-employment as defined in chapter 1.

To figure the deferral, you must use a reduced rate instead of the deferral contribution rate called for under the SARSEP. Use either the rate table or rate worksheet in chapter 5 to get the reduced rate. Then use the deduction worksheet to figure the deferral.

Compensation does not include tax-free items (or deductions related to them) other than foreign earned income and housing cost amounts.

Compensation of disabled participant. You may be able to choose to use special rules to determine compensation for a participant who is permanently and totally disabled. Under these rules, compensation means the compensation the participant would have received if paid at the rate paid immediately before becoming permanently and totally disabled. See Internal Revenue Code section 415(c)(3)(C) for details.

Tax Treatment of Deferrals

You can deduct your deferrals that, when added to your other SEP contributions, are not more than the limits under Deducting Contributions, earlier.

Elective deferrals that are not more than the limit discussed earlier are excluded from your employees' wages subject to federal income tax in the year of deferral. However, these deferrals are included in wages for social security, Medicare, and federal unemployment (FUTA) tax.

Excess deferrals. For 2001, excess deferrals are the elective deferrals for the year that are more than the $10,500 limit discussed earlier. The treatment of excess deferrals made under a SARSEP is similar to the treatment of excess deferrals made under a qualified plan. See Treatment of Excess Deferrals under Elective Deferrals (401(k) Plans) in chapter 4.

Excess SEP contributions. Excess SEP contributions are elective deferrals of highly compensated employees that are more than the amount permitted under the SARSEP ADP test. You must notify your highly compensated employees within 2 1/2 months after the end of the plan year of their excess SEP contributions. If you do not notify them within this time period, you must pay a 10% tax on the excess. For an explanation of the notification requirements, see Revenue Procedure 91-44 in Cumulative Bulletin 1991-2. If you adopted a SARSEP using Form 5305A-SEP, the notification requirements are explained in the instructions for that form.

Reporting on Form W-2. Do not include elective deferrals in the "Wages, tips, other compensation" box of Form W-2. You must, however, include them in the "Social security wages" and "Medicare wages and tips" boxes. You must also include them in box 12. Mark the "Retirement plan" checkbox in box 13. For more information, see the Form W-2 instructions.