Salary Reduction Simplified Employee Pension Plan (SARSEP) Explained

Julia Kagan is a seasoned financial and consumer journalist and former senior editor specializing in personal finance at Investopedia.

What Is the Salary Reduction Simplified Employee Pension Plan?

The Salary Reduction Simplified Employee Pension Plan (SARSEP) was a retirement savings plan designed for small business employees, enabling them to contribute pre-tax dollars to individual retirement accounts (IRAs) directly from their paychecks. SARSEPs were popular before the widespread adoption of 401(k) plans but are no longer available to new participants.

Key Highlights

• SARSEP was an early retirement plan option predating 401(k) plans.
• It allowed small business employees to make pre-tax IRA contributions via payroll deductions.
• New SARSEP plans have not been established since 1997.

Deep Dive into the Salary Reduction Simplified Employee Pension Plan (SARSEP)

SARSEP plans were primarily offered by small companies, typically those with 25 or fewer employees, allowing workers to save for retirement by reducing their taxable income through paycheck contributions to IRAs. These plans were a valuable employee benefit before 401(k)s became the norm. Following the enactment of the Small Business Job Protection Act of 1996, SARSEPs were phased out and succeeded by Savings Incentive Match Plans for Employees (SIMPLE plans).

SIMPLE plans offer enhanced flexibility for both employers and employees. Small businesses with up to 100 employees can participate, with employers required to make annual matching contributions. Additionally, employee contributions in SIMPLE plans are adjusted annually to account for inflation.

Although no new SARSEP plans have been created since January 1, 1997, existing SARSEPs were grandfathered in, allowing companies to enroll new employees under certain conditions. However, as time progresses, managing these legacy plans can become complex, especially when transferring accounts between financial institutions, prompting employees to explore alternative IRA funding methods.

The Evolution of Simplified Employee Pensions

Simplified Employee Pensions (SEPs) have long served as a workplace benefit, enabling employees to allocate income directly from their wages into tax-deductible retirement accounts. Employers often supplemented these contributions as an incentive.

Initially, SEPs funded individual retirement accounts, but with the introduction of 401(k) plans in the late 1970s, many employers shifted to these newer options due to their added flexibility.

Named after the relevant tax code section, 401(k) plans allow participants to defer taxes on income until withdrawal, typically at retirement when the individual’s taxable income may be lower. While early withdrawals are possible, they are discouraged due to immediate tax liabilities at current rates.

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