Who is eligible for participation?
Generally, any employee who performs services for your business must be included in a SARSEP. However, there are some exceptions to this general rule. Among the employees that may be excluded from a SARSEP are those who:
- Have not worked for the company during three out of the last five years.
- Have not reached age 21 during the year for which contributions are made.
- Are covered by a union agreement and whose retirement benefits were bargained for in good faith by the employees’ union and you.
- Are nonresident alien employees who have received no U.S. source wages, salaries, or other personal services compensation from you.
- Received less than $550 in compensation (subject to cost-of-living adjustments) during the year.
Only employers with 25 or fewer eligible employees in the prior year can permit employee elective deferrals in the current year. If you have more than 25 eligible employees this year, but had less than 25 employees in the preceding year, employee elective deferrals can be made this year. For example, if you had 23 eligible employees in year 2007, but 27 eligible employees in year 2008, employee elective deferrals may be made to the SEP-IRAs of the 27 employees for 2008. But in 2009, no employee elective deferrals may be made for you or your employees.
What are the contribution requirements?
By establishing a SARSEP, you, the employer, have adopted a plan that requires an IRA to hold the contributions made on behalf of each of your eligible employees. A SARSEP is funded by money that employees elect to defer from their salaries. Employer contributions are also allowed but only in the form of “nonelective” contributions. Nonelective contributions are employer contributions made to each eligible employee’s IRA - regardless of whether or how much the employee deferred into the IRA. Your SARSEP plan document will specify the nonelective contributions, if any, required under the plan.
Total contributions to each employee’s SEP-IRA cannot exceed the lesser of $46,000 for 2008 ($49,000 for 2009, and subject to cost-of-living adjustments for later years) or 25% of pay. (Employee elective deferrals are subject to lower limits.) Contributions made under the SARSEP - both employee elective deferrals and employer nonelective contributions - are 100% vested (or owned by) the employees. Publication 560 helps self-employed individuals determine the amount of their maximum deduction.
Participation test: Note that at least 50% of all eligible employees must make employee elective deferrals each year. If less than 50% of your eligible employees choose to make employee elective deferrals to the SARSEP for a year, all employee elective deferrals made by other eligible employees for that year are disallowed and must be withdrawn from the employees’ SEP-IRAs.
After you send the SARSEP contributions to the financial institution, the financial institution you selected will manage the funds. Depending on the financial institution, SARSEP contributions can be invested in stocks, mutual funds, and other, similar types of investments.
Each participating employee must receive an annual statement stating the amounts contributed to their account for the year.
SARSEP ADP Test: The employee elective deferrals of your highly compensated employees must meet the SARSEP ADP (average deferral percentage) 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 ADP of all eligible non-highly compensated employees.
Deferral Percentage: Each employee’s deferral percentage is the ratio of their elective deferrals for a year divided by their compensation for the same year.
The deferral percentage limitation must be computed each year. 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.
Top-Heavy Contributions: A SARSEP is top-heavy when more than 60% of all contributions go to key employees. 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% determination. When a SARSEP is top-heavy, non-key employees must receive a minimum employer contribution of up to 3% of pay. Check your SARSEP plan document.
What are the basic distribution/withdrawal rules?
SARSEP contributions and earnings can be withdrawn at any time. A withdrawal is taxable in the year received. If an employee makes a withdrawal before age 59½, generally a 10% additional tax applies. SARSEP contributions and earnings may be rolled over tax free to other IRAs and retirement plans.
SARSEP contributions and earnings must eventually be distributed. A specific minimum amount is required to be distributed by April 1 of the year following the year you reach age 70½. (For further details regarding the required minimum distribution amount, see Publication 590.)
How does a SARSEP work?
Geoffrey works for the Berea Dog Bone Company. Berea decides to establish a SARSEP for its employees. Berea has chosen a SARSEP because the dog bone business is cyclical in nature, with good times and down times. In good years, Berea can make larger contributions for its employees and in down times it can reduce the amount. Berea knows that under a SARSEP, matching contributions are not allowed. However, employers can make nonelective contributions to their employee’s accounts subject, of course, to the limits discussed above.
The financial institution that Berea has picked to work with for its SARSEP has several investment funds for the Berea employees to choose from. Geoffrey decides to divide the contribution to his SARSEP among three of the available funds.
What do I do if I make a mistake in operating my plan?
Generally, if the SARSEP fails to satisfy the requirements for SARSEPs, tax benefits can be lost. However, any error can likely be corrected by using one of the correction programs described in the Retirement Plans Correction Programs brochure.
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