1. Introduction – What is Publication 4407?
IRS Publication 4407, officially titled “Salary Reduction Simplified Employee Pension (SARSEP) – Key Issues and Assistance,” serves as the Internal Revenue Service’s official reference guide for managing legacy salary-reduction retirement plans. A review of IRS publications confirms that the foundational edition of Publication 4407 carries an official revision date of December 2017 (posted to the IRS repository in January 2018). While the core publication remains the active baseline, plan operations are governed by annual cost-of-living adjustments, which established an elective salary deferral cap of $24,500, a standard catch-up limit of $8,000 for workers 50 and older, a special age 60–63 catch-up of $11,250, and an overall annual contribution cap of $72,000.
A SARSEP is a unique retirement arrangement that blends features of a traditional Simplified Employee Pension (SEP) with salary deferral mechanics similar to a 401(k). The Small Business Job Protection Act barred businesses from creating new SARSEPs after December 31, 1996. However, any plan legally established before 1997 remains fully active, allowing both original participants and newly hired employees to make pretax contributions.
Publication 4407 was created specifically to address compliance hurdles identified during IRS audits. It outlines operational rules, mandatory testing formulas, and common administrative mistakes. This guide explains how to keep these grandfathered plans compliant without facing unexpected tax penalties.
2. Who Should Read This Publication
Publication 4407 is essential reading for small business owners who set up a SARSEP before 1997 and continue to fund it today. If you run a company with this type of grandfathered plan, you bear fiduciary responsibility for calculating contribution caps and conducting annual compliance tests.
Human resources managers, payroll administrators, and bookkeepers handling company payroll should also study this publication. Because SARSEP deductions require specific reporting on year-end tax forms, payroll professionals must understand how SARSEP rules differ from traditional 401(k) accounts.
Finally, financial advisors, tax return preparers, and plan participants benefit from this text. Employees who contribute to an established SARSEP can use it to verify whether their contributions fall within annual IRS boundaries.
3. Key Topics Covered
Publication 4407 focuses on the real-world mechanics of operating and maintaining a SARSEP plan. The guide targets common trouble spots rather than dry legal statutes.
- Eligibility and Participation Rules: Which employees must be allowed to participate and the minimum age and compensation requirements.
- The 25-Employee Restriction: The ongoing workforce limit that determines whether an employer may continue operating a SARSEP.
- The 50% Participation Requirement: The mandatory participation threshold required every single year.
- The Deferral Percentage Test (DPT): Non-discrimination testing that caps elective deferrals for business owners and high earners.
- Contribution Maximums: How annual cost-of-living limits apply to elective employee deferrals and employer matching contributions.
- Common Audit Errors and Fixes: Specific remedies to correct administrative failures before the IRS initiates an audit.
4. Detailed Breakdown of Main Concepts
The Grandfather Clause
Congress ended the establishment of new SARSEPs on December 31, 1996. Despite this cutoff, existing plans were grandfathered indefinitely. This means companies can keep their SARSEPs open and enroll new employees who join the company decades after the plan started.
The 25-Employee Headcount Limit
To maintain a SARSEP, an employer must not have employed more than 25 eligible employees at any time during the preceding calendar year. If your company expands beyond 25 eligible staff members, you can no longer accept employee salary deferrals and must transition to a modern retirement plan like a 401(k) or SIMPLE IRA.
The 50% Participation Rule
Each calendar year, at least 50% of all eligible employees must choose to make salary reduction contributions. If your business has 10 eligible workers, at least 5 must actively defer money into the plan during that year. If fewer than 50% elect to defer, no employee—including the business owner—is permitted to contribute elective deferrals for that year.
The Deferral Percentage Test (DPT)
To prevent tax advantages from favoring only upper management, SARSEPs require annual non-discrimination testing. The deferral percentage of each Highly Compensated Employee (HCE) cannot exceed 125% of the average deferral percentage of all non-highly compensated employees (NHCEs). If lower-paid staff members do not contribute sufficient percentages of their pay, high earners must have their elective deferrals reduced or refunded.
| SARSEP Requirement | IRS Rule Description | Annual Impact |
|---|---|---|
| Plan Establishment Date | Must have been formed before January 1, 1997 | No new SARSEP agreements can be established |
| Employer Size Cap | 25 or fewer eligible employees in prior year | Exceeding 25 halts employee elective deferrals |
| Participation Threshold | At least 50% of eligible staff must defer salary | Failing this removes elective deferral eligibility for the year |
| Non-Discrimination Limit | HCE deferral cannot exceed 125% of NHCE average | Excess contributions must be refunded or recharacterized |
5. Practical Examples or Scenarios
Scenario 1: Failing the 50% Participation Test
Clearwater Design established its SARSEP in 1994. In the current year, Clearwater employs 8 eligible team members. When enrollment forms are collected, only 3 employees choose to contribute salary deferrals, while 5 decide to take all their wages in cash.
Because only 37.5% of eligible workers elected to participate, Clearwater fails the 50% participation test. As outlined in Publication 4407, neither the owner nor any employee can make elective salary reductions for that calendar year. Any deductions already withheld must be promptly refunded to the participants as taxable wages.
Scenario 2: Applying the 125% Deferral Percentage Test
Apex Services operates a SARSEP with one owner (an HCE) and four eligible non-owner employees (NHCEs). The four non-owner employees defer 2%, 4%, 0%, and 2% of their salaries into their accounts. The average deferral percentage for the NHCE group is 2%.
The owner wishes to contribute the maximum possible percentage of her income. Multiplying the NHCE average (2%) by 125% yields a maximum allowable deferral rate of 2.5% for the owner. If the owner deferred 8% of her compensation, the excess amount above 2.5% fails compliance and must be distributed back to her to avoid severe tax penalties.
6. How This Publication Relates to Specific Forms
Understanding Publication 4407 requires familiarity with a small group of IRS tax forms used to establish, operate, and report SARSEP activity.
- Form 5305-A-SEP: This is the model agreement used by employers to create a SARSEP. While new forms cannot be drafted to create new plans, existing businesses retain their executed Form 5305-A-SEP as their governing plan document.
- Form W-2: Employee elective salary deferrals to a SARSEP are subject to Social Security and Medicare taxes, but exempt from federal income tax withholding. Employers must report these pretax deferrals in Box 12 using Code F.
- Form 5330: If an employer discovers excess contributions made by an HCE that were not corrected within 2.5 months following the close of the plan year, the employer must file Form 5330 to calculate and pay an excise tax.
- Form 5500 Series Exemption: Unlike traditional 401(k) plans, properly administered SARSEPs that utilize Form 5305-A-SEP do not require an annual Form 5500 informational return, keeping administrative costs low.
7. Common Misunderstandings Clarified
Many business owners believe that because SARSEPs cannot be newly established, newly hired employees cannot participate. This is incorrect. Any eligible new employee hired by a company with an active SARSEP has the legal right to participate under the terms of the original agreement.
Another frequent misunderstanding involves elective contribution limits. Business owners sometimes assume they can automatically contribute the maximum statutory elective deferral each year. In reality, HCE deferral limits depend entirely on what non-highly compensated employees choose to save.
Finally, taxpayers frequently confuse a standard SEP IRA with a SARSEP IRA. In a standard SEP, only the employer makes discretionary contributions; employees cannot contribute out of their own paychecks. A SARSEP uniquely allows both employee salary deductions and employer profit-sharing contributions.
8. Why This Publication Matters for Taxpayers
Maintaining a grandfathered SARSEP provides small businesses with significant cost advantages. Employers gain the primary benefits of a 401(k) plan—such as employee salary deferrals—without paying expensive third-party administration fees or filing complex annual reports.
However, the compliance risks of a SARSEP are sharp. Because the IRS conducts routine compliance checks on Employee Plans, an uncorrected mistake like failing the 50% participation rule can invalidate the entire plan. If an arrangement is disqualified, employee contributions become immediately taxable, and business tax deductions may be revoked.
Publication 4407 gives employers the exact checklist necessary to verify their calculations. Following its instructions protects the plan’s tax-deferred status and safeguards retirement savings for everyone in the firm.
9. Frequently Asked Questions
Can a business restart a SARSEP if it was dropped for several years?
If an employer validly established a SARSEP before 1997 and never formally terminated the plan agreement, the plan generally remains active. However, all eligibility and testing rules must be strictly met for the years contributions take place.
What happens if a company grows to 30 employees?
If your company employed more than 25 eligible employees at any point during the preceding tax year, you can no longer permit employee salary deferrals. The employer must stop elective contributions and consider opening another plan, such as a 401(k) or a standard SEP IRA.
Are catch-up contributions permitted under a SARSEP?
Yes. Employees age 50 and older are permitted to make additional catch-up contributions to their SARSEP IRAs up to the statutory limits. Catch-up contributions are not restricted by the 125% Deferral Percentage Test.
How are SARSEP contributions taxed upon withdrawal?
Because employee deferrals and traditional employer contributions go in on a pretax basis, all distributions in retirement are treated as ordinary income. Early withdrawals taken before age 59½ may also incur a 10% penalty tax unless an exemption applies.
10. Conclusion
IRS Publication 4407 is an indispensable compliance resource for the select group of small business owners operating grandfathered SARSEP retirement plans. Although federal law closed the door on new plans in 1996, existing plans remain efficient vehicles for retirement savings.
To preserve your plan’s qualified status, monitor the 25-employee threshold, ensure at least 50% participation annually, and perform the 125% deferral test for high earners. Using the guidance outlined in Publication 4407 ensures your business stays compliant while helping you and your workforce build a secure financial future.
