In regular SEP plans, the employer decides if it will make a contribution and how large that contribution will be. In a Salary Reduction SEP (SARSEP), employees choose to have the employer make contributions to their SEP-IRAs instead of paying them the equivalent amount as salaries. In this respect, SARSEPs are similar to a Cash or Deferred Arrangement or 401k plan — allowing the employee to defer income that would have otherwise would been have received (and taxed).

The maximum annual deferral amount for an employee’s “elective deferrals” is the same amount as for 401ks and tax-sheltered annuities:  $15,500 in 2007 (adjusted annually for inflation).  Eligible employees age 50 and older may contribute a additional $5,000 annually as a catch-up provision.  These limitations apply only to the amount by which an employee’s salary is reduced, and not to any contributions the employer chooses to fund.  The “regular SEP” rules discussed above apply to employer contributions in a SARSEP.

New SARSEPs have been prohibited since 1997, however, employers may continue to make contributions, under pre-1997 rules, to existing SARSEPs. In addition, employees hired after 1996, may participate in existing SARSEPs.  To maintain a SARSEP, an employer must have no more than 25 eligible employees.  At least 50% of the eligible employees must choose to participate — that is, make salary reduction contributions — in order for a SARSEP to continue in operation.