SEP IRAs: What You Need To Know

SEP IRA Overview

A simplified employee pension (SEP) individual retirement account (IRA) is an easy-to-manage retirement savings plan for self-employed entrepreneurs and small business owners and their employees. Any employer, including solopreneurs, can establish a SEP IRA. Contributions to a SEP IRA are tax-deductible and earnings are tax-deferred. 

SEP IRA withdrawals (a combination of before-tax dollar contributions and investment earnings) are taxed as ordinary income, typically in retirement. Like traditional and Roth IRAs, SEP IRA contribution limits are indexed annually for inflation.

A SEP IRA provides an affordable retirement plan solution for small businesses versus other types of plans that are often perceived as being too costly or complex. With a SEP, employer contributions are made directly to traditional IRAs that are established at a financial institution for the employer and each eligible employee.

Pros and Cons of SEP IRAs

Like other retirement savings plans, a SEP IRA is not an investment product per se. Rather, it is a tax-deferred “umbrella” account into which different investments are placed. 

These investments can include stocks, bonds, mutual funds (including index funds and target-date funds), exchange-traded funds or ETFs, and certificates of deposit (CDs). Business owners and their employees select their own investments based on personal factors such as age, investing experience, time horizon and investment risk tolerance.

Below are positive factors to consider when considering a SEP IRA versus other savings plans:

SEP IRAs are a convenient and powerful retirement savings tool for small business owners, but it is important to work closely with a tax advisor during the contribution process.  There are certain income calculations necessary to determine the appropriate contribution amount.    Be sure to understand the impact of using a SEP vs other options like a solo 401(k) before getting started.

Stephen Kates, CFP®, Licensed Life Insurance ProducerPrincipal Financial Analyst for Annuity.org

Stephen Kates, CFP® is a personal finance expert specializing in financial planning and education. He serves as the Principal Financial Analyst for Annuity.org, where he delves into industry trends to support consumers and financial advisors on wealth management, annuities, retirement planning, and investing.

SEP IRA Advantages

High Contribution Limit 

SEP IRA contribution limits are 10 times higher than those of traditional or Roth IRAs. In 2024, the maximum SEP IRA contribution is $69,000 versus only $7,000 for a traditional IRA ($8,000 if age 50+).

Low Administrative Costs 

SEP IRAs have less intensive reporting requirements and lower administrative expenses than more complex qualified retirement savings plans like a SIMPLE IRA, solo 401(k), Keogh plan or defined benefit pension.

100% Immediate Vesting 

Vesting is an employee’s right to employer-provided benefits. Immediate vesting means that SEP IRA account owners are instantly entitled to employer contributions to their SEP IRA and employers cannot take back this money.

Tax-Deductible Contributions 

SEP IRA contributions made by business owners are tax deductible. Contributions for self-employed individuals are deducted on Form 1040, Schedule 1 on the line that says, “Self-employed SEP, SIMPLE and qualified plans.”

Flexible Contributions 

Solopreneurs and small business owners with employees are not required to make annual SEP IRA contributions. If they have a year with low business earnings or other demands on their income, they can skip plan deposits or vary the contribution level from year to year.

Limited Fiduciary Liability 

The employer’s role is to make SEP IRA contributions. Employees own and control their individual SEP IRA investments and the distribution of their assets. This limits business owners’ liability as plan sponsors since employees bear the risk of losses resulting from their own investment decisions. 

Wide Range of Investment Options 

Many types of investments can be put into SEP IRAs by solopreneurs and small business employers and their employees. Prohibited assets are the same as those for other qualified plans including life insurance contracts, derivative securities such as options, and collectibles.

No Impact on Other Savings Plans 

Employees with a SEP IRA through an employer can also have another SEP for earnings from “side hustle” self-employment. In addition, they can have a traditional and/or Roth IRA by virtue of being workers with earned income.

As with any financial product, SEP IRAs also carry certain drawbacks that may dissuade you from incorporating one into your financial plan. These include:

SEP IRA Drawbacks

No Catch-Up Contribution Feature

Unlike traditional and Roth IRAs, there is no additional “catch-up” provision for older workers age 50+.

Employee Contribution Requirement

Employers who make contributions to their personal SEP IRA account must contribute the same percentage of income to employee accounts. This can be costly for employers, especially with high employee turnover since employees are immediately vested with no incentive for them to stay long term with a company.

For example, business owners who want to save 20% of their earned income must also contribute 20% of each employee’s compensation.

No Worker Contributions

SEP IRAs only allow employer contributions. Employees are not allowed to contribute any additional money to a workplace account. Instead, they only receive what their employer contributes.

Inconsistent Contributions

Plan deposits are at the discretion of employers, who can change SEP IRA contribution percentages annually, including no contribution at all. Therefore, employees cannot predict how much money will be saved on their behalf.

Required Minimum Distributions (RMDs)

Like other tax-deferred retirement savings accounts, SEP IRAs require taxable withdrawals starting at age 73 if born between 1951 and 1959 or age 75 if born in 1960 or later. RMDs can raise someone’s marginal tax bracket — and tax bill — later in life when they are added to other sources of retirement income.

Early Withdrawal Tax Penalty

Like other tax-deferred retirement savings accounts, withdrawals from SEP IRAs before age 59 ½ are not only taxed as ordinary income but subject to a 10% penalty unless an exception applies (for example, disability and homeownership exceptions may apply).

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SEP IRA Contribution Limits

SEP IRAs are similar to traditional IRAs in many ways (early withdrawal penalties, RMDs and tax-deductible contributions), but a significant difference is their contribution limit, which is much higher for SEP IRAs than for their traditional IRA counterparts.  

In 2024, employers can make an annual contribution of up to $69,000 or 25% of each employee’s compensation, whichever is less, with a $345,000 limit on compensation. 

To illustrate, if an employee earns $40,000 annually, his or her employer can contribute up to $10,000 to a SEP IRA. An employee earning $276,000 could receive the maximum $69,000.

For solopreneurs without employees, the contribution limit calculation is different. It is net earnings from self-employment, less the deduction for the contribution to the SEP IRA and the deduction for one-half of self-employment tax. The result is a maximum contribution of up to 20% of compensation or $69,000, whichever is less.

Who Is Eligible for a SEP IRA?

SEP IRAs work best for solopreneurs and small business owners with a few employees. Otherwise, they can get very expensive with mandatory employee contributions.

Employees are eligible to participate in a SEP IRA if they are at least 21 years old and have worked for an employer for three of the last five years. In 2024, the employee must also receive at least $750 in compensation during the year.

Employers can also elect less restrictive employee participation rules such as immediate participation or a shorter waiting period (for example, one year). Years are counted based on a calendar year and not from the date that an employee started working.

Do You Pay Taxes on a SEP IRA?

Typically, 100% of employer contributions to a SEP IRA are tax deductible for small businesses. Contributions are made with pre-tax earnings, and all investments within the account grow tax-free.

When account owners are 73 years old (age 75 if born in 1960 or later), they must begin taking RMDs from their SEP IRA account. The minimum withdrawal is calculated using two key numbers: the amount of money in the account on Dec. 31 of the previous year divided by the account owner’s life expectancy using a number in the IRS Uniform Lifetime table. For example, $100,000 ÷ 26.5 (the life expectancy divisor for age 73) = $3,774.

Employees can also roll over their SEP IRA funds into another qualified account, such as a traditional IRA, without facing tax penalties.

The SECURE 2.0 Act allows employers to offer tax-free Roth SEP IRA accounts — those funded with after-tax dollars — starting in 2023. However, IRS rules are still being developed and most large SEP IRA plan providers do not currently offer Roth accounts.

Choosing Between a Solo 401(k) and SEP IRA

A solo 401(k) plan is a relatively new retirement savings plan designed exclusively for sole proprietors with a single employee — the business owner. It can also apply to the owner’s spouse if he or she is the company’s only other employee. There are three key differences between solo 401(k)s and SEP IRAs.

First, solo 401(k)s allow solopreneurs to save as both an employer (up to 25% of compensation) and an employee (up to $23,000 in 2024) so they can save more money in a solo 401(k) than in a SEP. This is beneficial for late savers making up for lost time.

Second, solo 401(k)s allow account owners to borrow against their loan balance. They can also take out a loan equal to the lesser of $50,000 or 50% of the solo 401(k) account balance. SEP IRAs do not offer loans.

Third, solo 401(k)s offer a Roth option — contributions made with after-tax dollars and tax-free withdrawals with no RMDs. This can be a good option for business owners who think their income and tax rate are lower now than they will be in retirement.

Solo 401(k) plan participants must formally elect to make a deferral contribution by Dec. 31 of each tax year. However, the actual contribution can be made by the tax filing deadline (on or around April 15, or Oct. 15 if an extension was filed). The contribution deadline for a SEP IRA is also the tax filing deadline.

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How To Set Up a SEP IRA

It’s relatively easy to establish a SEP IRA.

You can open one at almost any bank, mutual fund company or brokerage firm. If you have employees, a financial institution will serve as trustee of the SEP IRA and hold each worker’s retirement plan assets.

Setup Process 

Follow these three steps:

1. Execute a written agreement to provide benefits to all eligible employees.
2. Educate employees about the agreement.
3. Set up an IRA account for each employee.

The written agreement must include the employer’s name, requirements for employee participation, the signature of a responsible official and a set allocation formula.

Employers may be eligible for a tax credit of up to $500 per year for each of the first three years for the cost of starting a SEP IRA. The credit is designed to compensate employers for costs of setting up and administering a SEP IRA and educating employees about it.

Forms

The IRS provides a model SEP document on its website, Form 5305-SEP. Employers who use Form 5305-SEP must give their employees a copy along with instructions. This includes requirements for receiving a distribution from the plan.

Alternatively, employers can use a prototype document provided by a mutual fund, bank or other qualified financial institution, or they can create their own.

After the first contribution, employers and their eligible employees will receive a statement from the financial institution and an annual statement each year after that.