Tax Implications for Switching From a SARSEP to a Roth IRA

Tax Implications for Switching From a SARSEP to a Roth IRA
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The Salary Reduction Simplified Employee Pension individual retirement account (SARSEP IRA) is an employer-sponsored tax-deferred retirement savings account. It allows employees and employers to make tax-deductible contributions to the employee’s retirement fund. New SARSEP plans were halted in 1997, but existing plans have been allowed to continue. Employees in a SARSEP-IRA can switch their retirement funds to a Roth IRA, but will pay taxes on the transaction.

Tax Difference

A rollover to another retirement plan is considered a distribution from your retirement plan. If you rolled over from a SARSEP-IRA to another type of tax-deferred retirement plan, such as a traditional IRA, it would be a tax-free distribution. However, a Roth IRA is based on after-tax contributions, meaning you forego a tax deduction in the year you made a Roth contribution in return for tax-free distributions at retirement. When you take a distribution from a tax-deferred SARSEP-IRA to roll over into an after-tax Roth IRA, that taxation difference must be accounted for in the rollover transaction.

Deferred Taxes

Your SARSEP IRA includes annual contributions from your employer that he can deduct, and annual contributions from you that your employer deducts from your taxable salary. Your employer and you can each contribute up to 25 percent of your salary to your SARSEP IRA. When you take a distribution from your SARSEP IRA to invest in a Roth, you will owe the IRS the deferred taxes on both your contributions and those made by your employer.

Age 59 1/2 Rule

If you are under age 59 1/2 and roll over the SARSEP IRA into your Roth IRA by a direct plan-to-plan transfer, the amount rolled over counts as taxable income and you will owe income tax on it. But because it is a direct rollover and not a payment to you, the 10 percent penalty tax on withdrawals before age 59 1/2 doesn’t apply.

Indirect Rollover

If you switch by an indirect rollover, the tax picture is a bit more complicated. In an indirect rollover, the SARSEP IRA would pay the distribution to you and you would have 60 days to deposit the money into your Roth IRA. But in an indirect rollover the SARSEP IRA fiduciary must withhold 20 percent of the distribution for taxes. If you deposit the remaining 80 percent in your Roth IRA within the 60 day window, you will owe income taxes, but not the 10 percent penalty tax on that amount. You would owe both income tax and the 10 percent penalty tax on the withheld amount. But if you replaced the withheld amount from other funds, and deposited the money into your Roth within the 60 day window, you would avoid the penalty tax.