What Is the Salary Reduction Simplified Employee Pension Plan?

Salary Reduction Simplified Employee Pension Plan (SARSEP) was a type of retirement plan once offered by small companies that allowed employees to make pretax contributions to individual retirement accounts (IRAs) through salary reduction. No longer issued, these plans predated the widespread use of 401(k) retirement plans.

Understanding the Salary Reduction Simplified Employee Pension Plan (SARSEP)

Salary Reduction Simplified Employee Pension Plan (SARSEP) retirement plans were offered by small companies, usually with 25 or fewer employees, that allowed for pretax contributions to individual retirement accounts through paycheck deductions. SARSEP plans were a valuable benefit of employment, particularly for employees of small businesses prior to the widespread implementation of 401(k) retirement plans. After the passage of the Small Business Job Protection Act of 1996, SARSEPs were discontinued and replaced by a new type of plan, known as a Savings Incentive Match Plan for Employees, or SIMPLE plan. 

SIMPLE plans provide more options for both employers and employees. For instance, small companies with up to 100 employees are able to participate in SIMPLE plans. Employers are required to make an annual matching contribution to these plans, and employee contributions are adjusted for inflation. 

While no new SARSEPs were created after January 1, 1997, existing plans were allowed to remain in place, and companies with active SARSEPs were able to grandfather new employees into their existing plans after that date so long as they continue to meet certain requirements.

As time goes on, some employers which maintained SARSEPs after 1997 could run into complications especially as they move accounts between financial service providers, requiring some employees to determine alternate pathways to directing income into their IRAs.

Origins of Simplified Employee Pensions

For many decades, simplified employee pensions (SEPs) have been featured as an employment benefit, permitting employees to channel income directly from their paycheck into a tax-deductible retirement plan. In many cases, employers would provide an additional contribution to an employee's SEP as an added incentive.

In early implementations, SEPs would pay into the beneficiary’s individual retirement account. When 401(k) plans became available in the late 1970’s, these accounts became more popular options for employers.

Named after the tax code regulation that defines the retirement plan, a 401(k) functions as tax-deferred income, meaning that taxes will be due on the income when it is withdrawn. This retirement plan operates under the presumption that when the 401(k) fund is paid out to the employee, they will have reached retirement age and position in which their overall taxable income may be lower. While an employee may typically be able to cash out their 401(k) account at an earlier date, this practice is disincentivized as the employee is then responsible for taxes at the current rate.