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What is a SEP IRA and how does it work?

June 10, 2022 • 6 min read

What we'll cover

  • Definitions of a SEP and IRA

  • How a SEP IRA works

  • The difference between an IRA and a SEP IRA

Saving for your future shouldn’t be considered optional. But when it comes to how you save, there are plenty of choices. While most people include an individual retirement account (IRA) among their retirement savings tools, not all IRAs are the same. Here’s one valuable IRA for small businesses: a SEP IRA.

Read on to learn the basics of SEP IRAs and how they work. We’ll explain some differences between other types of savings vehicles, walk through the rules of a SEP plan for self-employed individuals and how to set one up. We’ll also cover the SEP IRA contribution deadline.

SEP IRA, defined

What is SEP, anyway? It stands for “Simplified Employee Pension,” and if you’re looking for 401(k) alternatives for small businesses or if you’re self-employed, the SEP IRA may make sense. A SEP IRA is an individual retirement plan that allows employers to make tax-deductible contributions on behalf of employees, including self-employed individuals.

For example, in a sole proprietorship, you would be both the employer and the only employee. In this case, you’d be able to make tax-deductible contributions into your own retirement account without having to meet the eligibility requirements of traditional IRAs. Employers receive tax deductions for plan contributions, which are made to each eligible employee’s SEP IRA on a discretionary basis.

How a SEP IRA works

An IRA trustee determines eligible investments and employer contributions fund SEP IRAs — they have few excess administrative costs and are available from most major brokerage firms. They work like other IRA retirement plans, such as traditional IRAs — the same investment, distribution, transfer and rollover rules apply to traditional IRAs and SEP IRAs. The funds in a SEP IRA are owned and managed by individual employees.

The money contributed to the account is tax deductible for the employer and your investments grow tax deferred.

What is the difference between an IRA and a SEP IRA?

A SEP IRA follows investment, distribution and rollover rules like a traditional IRA but offers a $66,000 maximum annual contribution limit in 2023. (In 2023 traditional IRA limits contributions are just $6,500 and $7,500 for those 50 or older.)

SEP IRA vs. individual 401(k)

An individual 401(k), also called a Solo 401(k), is a retirement account designed for self-employed individuals with no full-time employees. If you want to invest in a Solo 401(k), you can’t have a business with employees — you must use a SEP IRA.

SEP IRA rules

What are the SEP IRA rules? An employer who offers a SEP IRA is not obligated to contribute a minimum amount or fund any accounts. However, an employer who offers a SEP IRA must contribute the same amount to both their own SEP IRA and the SEP IRA of eligible employees and contributions to the SEP IRA of each owner and employee must be equal. For example, if as an employer you put in 10% of your pay, you must contribute at least 10% to employees’ pay.

If you’re an employer and have employees who want to take part in your plan, they must be:

  • Age 21 or older

  • Have worked for you for at least three of the past five years

  • Made a minimum of $750 in 2023 ($600 in compensation for 2021
    and 2022)

If you’re an employee, you’ll receive the IRS Form 5305-SEP or the prototype plan document as well as other documents and disclosures. You’ll also learn about changes to the plan and an annual statement as well.

Pro tip: Note that you can’t make catch-up contributions if you’re 50 or older, like you can with a traditional or Roth IRA.

SEP IRA contribution deadline 2023

Any money you want to put into a SEP IRA will need to go into your account by the time your business files taxes for that year. For the current year, the 2023 SEP IRA contribution deadline is April 15, 2023.

SEP IRA contribution limits

In 2023, SEP IRA contribution limits are 25% of your pay or $66,000,
whichever is less.

SEP IRA withdrawal rules

You must pay taxes on your withdrawals at retirement and must adhere to withdrawal rules if you don’t want to pay a penalty. If you make a withdrawal before age 59½, you’ll have to pay a penalty and income taxes on the amount. When you turn 70½, you must take annual minimum distributions, according to the IRS .

What are the advantages of a SEP IRA?

Like traditional IRA funds, money in an SEP IRA can grow tax-deferred until retirement. Because there’s no minimum annual contribution, businesses can forgo making contributions in leaner years. When money is withdrawn in retirement, the funds are taxed at the same rate as ordinary income, which means it follows the regular income tax bracket rates, which are as follows in 2023: 10%, 12%, 22%, 24%, 32%, 35% and 37%. (Keep in mind that the tax rules could change in the future!)

A SEP IRA can provide the flexibility small businesses and sole proprietorships need to provide for themselves and their employees’ retirement.

Tax advantages

Because it’s a type of traditional IRA, a SEP IRA allows an employer to deduct contributions in the year they are made. That means you can deduct the amount you deposit into your SEP IRA from your taxable income, so you pay less income tax for the year. That’s good news for a business trying to make the most of limited funds.

In addition, any growth in the IRA is tax-deferred until you (or your employees) withdraw funds. Note that the same transfer and rollover rules that apply to traditional IRAs also apply to SEP IRAs.

Flexible annual contributions

SEP IRAs offer quite a bit of flexibility when it comes to annual contributions. For one thing, SEP IRAs have significantly higher annual contribution limits than other types of IRAs — around 10 times higher.

Putting away tax-advantaged funds in those higher amounts can really amp up your earning potential over the years. (Check the IRS website for the most current contribution limits from year to year.)

Not only are the contribution limits of SEP IRAs generous, but the amounts (up to the limit) are entirely up to you as the business owner. That means that in lean years, you can choose not to contribute at all. In more profitable years, you can choose a larger amount that makes sense for you.

Everyone in your company benefits

SEP IRAs can be a simple retirement plan for yourself if you’re a one-person show, or for yourself and your employees. A couple things to understand: If you offer the SEP IRA plan to your employees, you must open a separate SEP IRA for each individual. Keep in mind that employers make contributions to the SEP IRAs of their employees — employees cannot save their own earnings in those accounts.

Easy to open

Another thing that makes SEP IRAs popular with small business owners is that they’re simple to set up and easy to manage. If you’re a business owner with one or more employees or you have freelance income, you can open a SEP IRA at a bank or brokerage firm in just a few steps. Note that online banks often offer higher rates than brick-and-mortar banks.

What are the disadvantages of a SEP IRA?

There are a few disadvantages to SEP IRAs, including:

  • No “catch-up” contribution options. If you're 50 and older, there are no ‘catch-up’ contributions like there are for Roth IRAs or traditional IRAs.

  • Employers must contribute the same percentage to employees that they contribute to their own SEP IRA account.

  • You’ll pay income-based taxes and a 10% penalty if you take out money before age 59½.

  • There’s no Roth option, which means you can’t pay taxes now and take them out tax-free in retirement.

What are the disadvantages of a SEP IRA?

There’s really nothing to setting up your SEP IRA account online. First, read through and fill out IRS Form 5305-SEP or through your account provider and give your employees the form.

Finally, set up an account for each employee, following your account provider’s instructions.

A SEP IRA for your retirement

Now that you know the answer to, “What is a SEP IRA plan?” you may look to a SEP IRA as a way to contribute to a tax-advantaged retirement plan. It offers you the chance to contribute a hefty sum each year and have your savings grow tax deferred.

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