A SARSEP plan, short for Salary Reduction Simplified Employee Pension, is a retirement arrangement that lets employees make pre-tax contributions into their own SEP-IRAs much the way a 401(k) works. Congress closed the door on new SARSEPs after 1996, but employers who set one up before January 1, 1997 can keep it running indefinitely, and employees hired after that date can still join an existing plan.1Internal Revenue Service. SARSEP Fix-It Guide – Overview For 2026, participants can defer up to $24,500 of their pay, and the plan carries testing rules that catch a lot of small employers off guard.
Who Can Still Participate
A SARSEP can only keep operating if the employer had 25 or fewer eligible employees at any point during the preceding year.2Internal Revenue Service. Salary Reduction Simplified Employee Pension Plan Cross that headcount and salary reduction contributions have to stop for the year. It’s a hard cap, which is why SARSEPs don’t fit any business with real growth.
On the employee side, three conditions all have to be met:
- At least 21 years old.
- Worked for the employer in at least three of the preceding five years.
- Received at least $800 in pay from the employer during the year (the 2026 threshold, adjusted annually).3Internal Revenue Service. Notice 25-67 – 2026 Cost-of-Living Adjustments
Those are the minimums. A plan document can be more generous but not stricter. Part-time and seasonal workers who clear all three bars are eligible and have to be counted in.
Contribution Limits for 2026
Elective deferrals into a SARSEP follow a dual limit: the lesser of a flat dollar cap or 25 percent of the employee’s compensation.4Internal Revenue Service. SEP Contribution Limits (Including Grandfathered SARSEPs) For 2026 the dollar cap is $24,500.5Internal Revenue Service. COLA Increases for Dollar Limitations on Benefits and Contributions That 25-percent-of-compensation ceiling is unique to SARSEPs and can pinch middle earners: someone earning $80,000 is capped at $20,000 in deferrals despite the higher statutory limit.
Catch-Up Contributions
Participants aged 50 or older can add another $8,000 above the standard limit in 2026. SECURE 2.0 introduced a higher catch-up for participants who turn 60, 61, 62, or 63 during the year. For 2026 that enhanced amount is $11,250 instead of $8,000.5Internal Revenue Service. COLA Increases for Dollar Limitations on Benefits and Contributions Catch-up amounts aren’t subject to the 25-percent-of-compensation limit.
Employer Contributions
Employers can add nonelective contributions to each eligible employee’s SEP-IRA on top of what the employee defers. Matching contributions are not allowed in a SARSEP.1Internal Revenue Service. SARSEP Fix-It Guide – Overview Total contributions from all sources cannot exceed the lesser of 25 percent of compensation or $72,000 for 2026, and only the first $360,000 of an employee’s compensation can be used in the math.4Internal Revenue Service. SEP Contribution Limits (Including Grandfathered SARSEPs) Self-employed participants compute their contribution from net self-employment earnings after deducting half of self-employment tax and the contribution itself, which pulls the effective rate below the nominal 25 percent; IRS Publication 560 has the rate table and worksheets.
The Tests That Trip Up SARSEPs
Two annual tests do most of the damage in SARSEP compliance, and both are stricter than what a 401(k) plan lives with.
The 50-Percent Participation Test
Every year, at least half of all eligible employees must actually defer salary into the SARSEP. If participation falls below that line, every elective deferral made that year is disallowed, and every participant has to withdraw the money from their SEP-IRA.6Internal Revenue Service. SARSEP Fix-It Guide – Less Than 50% of Eligible Employees Made Employee Elective Deferrals The withdrawn amounts become taxable in the year they were originally deferred.
When the test fails, the employer has to notify each affected employee within two and a half months after the plan year ends. For a calendar-year plan that’s March 15. The notice must state the disallowed dollar amount, the tax year those deferrals become taxable, and what happens if the employee doesn’t withdraw the money.7Internal Revenue Service. Retirement Plans FAQs Regarding SARSEPs This is the single most common SARSEP failure, because part-timers and seasonal workers who meet eligibility count in the denominator whether they want to participate or not.
The Deferral Percentage Test
A SARSEP also has to pass an annual deferral percentage test aimed at highly compensated employees. Each HCE’s individual deferral percentage cannot exceed 1.25 times the average deferral percentage of the non-highly compensated employees.8Office of the Law Revision Counsel. 26 USC 408 – Individual Retirement Accounts That’s the strict part: a 401(k) plan compares averages of HCEs to averages of NHCEs, so a high-deferring HCE can be balanced by a low-deferring one. SARSEPs allow no such averaging, so one aggressive HCE can blow the test even if others defer modestly.9Internal Revenue Service. SARSEP Fix-It Guide – You Didn’t Pass the Annual Deferral Percentage Test
For 2026, an HCE is any employee who earned more than $160,000 in the prior year.3Internal Revenue Service. Notice 25-67 – 2026 Cost-of-Living Adjustments The employer can’t shore up a failing test with nonelective contributions, either.9Internal Revenue Service. SARSEP Fix-It Guide – You Didn’t Pass the Annual Deferral Percentage Test
When the test fails, the employer must notify each affected HCE of their excess contribution within two and a half months after the plan year ends (March 15 for calendar-year plans). Miss that deadline and a 10-percent excise tax hits the excess. The employee then has until April 15 of the year following notification to pull the excess and any earnings out of the SEP-IRA.9Internal Revenue Service. SARSEP Fix-It Guide – You Didn’t Pass the Annual Deferral Percentage Test The withdrawn amount is taxable in the year it was originally deferred.
Top-Heavy Minimums
A SARSEP becomes top-heavy when more than 60 percent of employer contributions go to key employees. Key employees for 2026 include officers earning more than $235,000 and certain business owners. In a top-heavy year, the employer has to make a minimum contribution for every non-key eligible employee equal to the lesser of 3 percent of compensation or the highest contribution percentage made for any key employee.10Internal Revenue Service. SARSEP Fix-It Guide – You Didn’t Make Required Top-Heavy Minimum Contributions to the SARSEP Many SARSEP plan documents assume the plan is always top-heavy, which sidesteps the annual 60-percent calculation.
SECURE 2.0 Wrinkles
Two SECURE 2.0 provisions matter for SARSEP participants. The enhanced catch-up for ages 60 through 63 applies, raising the 2026 catch-up from $8,000 to $11,250 for anyone in that window.5Internal Revenue Service. COLA Increases for Dollar Limitations on Benefits and Contributions
Section 601 of SECURE 2.0 also created a Roth option for SEP-IRAs, and Section 604 lets employers designate nonelective contributions as Roth.11Internal Revenue Service. SECURE 2.0 Act Changes Affect How Businesses Complete Forms W-2 If the SARSEP plan document is amended to permit Roth elective deferrals, participants can put in after-tax dollars and eventually take tax-free qualified distributions. The practical catch is whether the custodian holding the SEP-IRAs supports Roth sub-accounts, so confirm before amending.
Withdrawals From the SEP-IRA
Because contributions land in a SEP-IRA, distributions follow standard IRA rules. Money taken before age 59½ generally faces a 10-percent early withdrawal tax on top of ordinary income tax.12Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions The usual exceptions waive the penalty:
- Total and permanent disability of the account owner.
- Distributions to beneficiaries after the account owner dies.
- Unreimbursed medical expenses exceeding 7.5 percent of AGI.
- Up to $10,000 for qualified first-time homebuyers.
- Qualified higher education expenses.
- A series of substantially equal periodic payments over the owner’s life expectancy.
- Health insurance premiums after receiving unemployment compensation for at least 12 weeks.
- Up to $22,000 for losses from a federally declared disaster.
- Up to $5,000 per child for qualified birth or adoption expenses.
Required minimum distributions have to start by April 1 of the year after the participant turns 73. SEP-IRA balances can also be rolled tax-free into a traditional IRA, a 401(k), or another eligible retirement plan at any time, which comes in handy if the employer shuts the SARSEP down or the participant leaves.
If Your Employer Is Ending the SARSEP
Plenty of employers eventually close their SARSEPs, and the IRS explicitly says it shouldn’t be notified of a termination.7Internal Revenue Service. Retirement Plans FAQs Regarding SARSEPs The employer stops accepting contributions, tells employees the plan is done, and informs the custodian. All assets in participants’ SEP-IRAs are fully vested and stay with the employee, who can keep the account open, take distributions, or roll the balance elsewhere.
Most employers replace a SARSEP with one of two options. A SIMPLE IRA was designed as the successor: it requires either a dollar-for-dollar match on the first 3 percent of deferrals or a flat 2-percent nonelective contribution for every eligible employee, and it has no annual nondiscrimination testing, though contribution limits are lower.2Internal Revenue Service. Salary Reduction Simplified Employee Pension Plan A 401(k) is the other common move, with higher overall limits, Roth and loan options, no cap on the number of employees, and much heavier administration in return.