The Salary Reduction Simplified Employee Pension individual retirement account (SARSEP IRA) is an employer-sponsored tax-deferred retirement savings account. Businesses that participated in this plan had to have 25 or fewer employees eligible to participate in it.
The SARSEP IRA 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 and can be used even by employees hired after 1996.
However, employees can perform a SARSEP rollover to IRA, even a Roth one, so long as they are willing to pay taxes on the transaction.
SARSEP-IRA to Roth Rollover: Tax Implications
A rollover to another retirement plan is considered a distribution from your retirement plan. It usually happens when you transfer your retirement assets from an employer-sponsored plan to an IRA of some sort. And the rules guiding the process vary depending on what kind of IRA you will be moving your assets into.
For example, 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. That is because these two types of retirement accounts are subject to similar taxation rules. In this case, you get to withdraw money from them at retirement and pay taxes on the distributions because the contributions consist of pre-tax income.
However, a Roth IRA usually contains 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. And that is why you must pay taxes during the transaction.
SARSEP IRA to Roth Rollover: 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.
You and your employer can each contribute up to 25 percent of your salary ($290,000 is the maximum compensation used for calculation) or up to $19,500 in employee elective deferrals to your SARSEP IRA. However, if you are 50 years or older, you can contribute an additional $6,500 in elective deferrals.
So, 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.
SARSEP Rollover to IRA: The Minimum 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. However, the 10 percent penalty tax on withdrawals before age 59 1/2 doesn’t apply because it is a direct rollover and not a payment to you.
SARSEP IRA to Roth IRA: Indirect Rollovers
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. However, 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.
It pays to be careful when rolling over assets from a SARSEP rollover to an IRA of the Roth kind. Due to the difference in the way these accounts are funded and distributions are taxed, you could end up making a costly mistake. So, consider asking for professional financial advice if you do not know what to do.
Herb Kirchhoff has more than three decades of hands-on experience as an avid garden hobbyist and home handyman. Since retiring from the news business in 2008, Kirchhoff takes care of a 12-acre rural Michigan lakefront property and applies his experience to his vegetable and flower gardens and home repair and renovation projects.