Understanding the tax-advantaged SEP IRA

Understanding the tax-advantaged SEP IRA

11.03.2023

What is a SEP IRA?

A SEP IRA — short for simplified employee pension plan — is a tax-advantaged retirement plan designed for business owners. While it can be used by businesses of any size, it’s often used by small business owners and self-employed individuals.

A SEP IRA has many of the same benefits as other tax-advantaged retirement accounts, including individual retirement accounts (IRAs) and 401(k) plans. However, SEP IRAs have different eligibility requirements and contribution limits.

How does a SEP IRA work?

A SEP IRA is an employer-sponsored retirement plan often used by small business owners and self-employed individuals. Any business owner can open a SEP IRA to save for their own retirement, as well as their employees’ retirement.

The money contributed to a SEP IRA is pre-tax. However, because only the employer can make contributions, it’s the business and not the employee that enjoys the upfront tax benefits.1 The money in a SEP IRA then grows tax-deferred. Finally, SEP IRA distributions during retirement are subject to ordinary income taxes.

A SEP IRA differs from other workplace retirement plans because employees aren’t able to contribute. Instead, only the company can contribute to each employee’s account. Also unlike other plans, employees are always 100% vested in their SEP IRA, meaning as soon as an employer makes a contribution on their employee’s behalf, it belongs entirely to the employee.

One catch with SEP IRAs — and a reason larger employers may not choose to use them — is that contributions must be equal for all employees.

Suppose you start a business and decide to put 10% of your salary into a SEP IRA. But then you hire an employee. And because you must contribute equally for all employees, you must either contribute 10% of your employee’s wages into their SEP IRA or reduce your own contributions.

Like other retirement accounts, money that’s been contributed to a SEP IRA can be invested in a variety of investments. Employees make their own investment decisions about their SEP IRAs. Investment options are likely to include stocks, bonds, mutual funds, exchange-traded funds (ETFs), money market funds, and more.

Who can open a SEP IRA?

Technically any business owner can open a SEP IRA. However, because of how easy they are to set up and the fact that they require equal contributions for all employees, they are most often used by small business owners with few or no employees.

In fact, you don’t even technically need to have an established business to open a SEP IRA. Anyone who has self-employed income can open a SEP IRA, including freelancers and gig workers who aren’t considered employees.

Read more: Small business IRA

For businesses that do choose to offer SEP IRAs to their employees, the IRA allows employers to set minimum requirements that employees must meet to become eligible. An employer can decide to use less restrictive eligibility requirements but not more restrictive ones.

Here are the SEP IRA minimum eligibility requirements set by the IRS:

  • Be at least 21 years of age
  • Work for the employer for at least three of the past five years
  • Receive at least $750 in compensation in 2023 ($650 in 2022 and 2021, $600 for 2020 and 2019)

Employers can choose not to include employees in their SEP IRA plan if they are covered by a union agreement where retirement benefits were bargained in good faith by the employer and the union or if they are nonresident alien employees without U.S. wages or salaries.

How much can you contribute to a SEP IRA?

In 2023, employer contribution limits for each eligible employee are limited to the lesser of $66,000 or 25% of that person’s compensation.

For example, if someone has an income of $264,000, the employer may contribute the full $66,000 since that is 25% of the person’s compensation. But if that employee only earns $100,000, then contributions are limited to $25,000.

The deadline for SEP IRA contributions is tax day the following year. For example, for the 2023 tax year, employers can contribute to their SEP IRAs until their tax filing deadline.

How to set up a SEP IRA

Setting up a SEP IRA for your business is a relatively easy process, which is part of what makes this type of account so popular for small business owners and self-employed individuals. Here’s how to get your SEP IRA set up:

  1. Choose a financial institution. This institution will serve as the trustee or custodian of the SEP IRA and will hold each employee’s retirement plan assets.
  2. Execute a written agreement. You must create a written agreement and share it with all eligible employees. It must include the employee's name and plan participation requirements. The IRS has a model SEP plan document that employers can use: Form 5305-SEP, Simplified Employee Pension - Individual Retirement Accounts Contribution Agreement.2
  3. Give employees information about the SEP IRA. You must let your employees know you’ve established the plan, the requirements for receiving a contribution, and the basis on which contributions will be allocated. The plan isn’t considered adopted until all eligible employees have received information about it.
  4. Set up SEP accounts for each employee. The employer can set up the SEP IRA on behalf of each employee, or an employee can set up their own.
  5. Start contribution to each employee’s account. You must contribute the same percentage of income to each employee’s account but can change or pause contributions from year to year (as long as it's done for all employees).

SEP IRA rules and regulations

Employers are subject to certain notice and disclosure requirements when operating a SEP IRA.

They must provide employees with the following:

  • A copy of IRS Form 5305-SEP or whatever written plan agreement the employer is using in place for that form
  • Notice of any amendments to the employer’s SEP plan, as well as any new requirements
  • An annual contribution statement

SEP IRA pros & cons

Pros of SEP IRA

  • High contribution limit: The maximum SEP IRA contribution limit is $66,000 in 2023, which is considerably higher than the contribution limits on traditional or Roth IRAs and on the employee limit for 401(k) plans.
  • Ease of setup and administration: SEP IRAs are easier than other workplace retirement plans to set up and maintain, which makes them so attractive to self-employed individuals.
  • Tax-deductible contributions: As a self-employed individual, your business can deduct your SEP IRA contributions. Those contributions aren’t considered taxable income and aren’t subject to FICA taxes.
  • Flexibility in contributions: Though you must contribute the same percentage for each employee, you can change or pause contributions at any time.

Cons of SEP IRA

  • No catch-up contributions for savers 50 or older: Unlike other tax-advantaged retirement accounts, SEP IRAs don’t have an increased contribution limit for people ages 50 and older.
  • Absence of a Roth version: A SEP IRA must be set up as a traditional IRA, meaning there is no Roth option and no ability to enjoy tax-free distributions in retirement (unless you later do a Roth IRA rollover).
  • Required proportional contributions for eligible employees: As a business owner, you must contribute the same percentage of wages to all eligible employees. If you contribute 10% of your own wages, you must also contribute 10% on behalf of all your employees.
  • Minimum distributions and age requirement: SEP IRAs are subject to required minimum distributions (RMDs), which means you must begin taking withdrawals (and paying taxes on them) at age 73. You’ll also face tax penalties for early withdrawals.

SEP IRA vs. Roth IRA

A Roth IRA is a highly popular retirement plan, especially for young workers and those relatively early on in their careers. While both SEP IRAs and Roth IRAs have important tax advantages, they differ in some important wages:

Availability

All business owners — even freelancers and gig workers — are eligible to set up and contribute to SEP IRAs. And any employees who meet the plan’s eligibility requirements are also able to have the business contribute on their behalf.

Roth IRAs aren’t limited to employees at certain businesses, nor are they limited to only business owners. However, there are income limits on Roth IRA contributions.3 You can only contribute to a Roth IRA if you fall within the income thresholds in the following table.

Filing status

Modified AGI

Contribution limit

Married Filing Jointly or Qualified Widower

Less than $218,000

$6,500

Married Filing Jointly or Qualified Widower

$218,000 - $228,000

Reduced amount

Married Filing Jointly or Qualified Widower

$228,000 or more

$0

Married Filing Separately

Less than $10,000

Reduced amount

Married Filing Separately

$10,000 or more

$0

Single or Head of Household

Less than $138,000

$6,500

Single or Head of Household

$138,000 - $153,000

Reduced amount

Single or Head of Household

$153,000 or more

$0

Tax advantage

Employers can claim a tax deduction for contributions they make to their employees’ SEP IRAs. Additionally, the contributions don’t count as income for the employees and aren’t subject to payroll taxes. The money grows tax-deferred in the account, but employees will pay income taxes on distributions during retirement.

A Roth IRA, on the other hand, only takes after-tax dollars, meaning no one gets a tax break in the year the contribution is made. However, the money grows entirely tax-free in the account, and all qualified distributions are made tax-free.

Read more: What is a non-deductible IRA?

Contribution limits

SEP IRAs and Roth IRAs have very different contribution limits, and this is one of the areas where a SEP IRA really shines for business owners. As a self-employed individual, you can contribute the lesser of $66,000 or 25% of your income to a SEP IRA in 2023.

But individuals in 2023 may only contribute up to $6,500 to a Roth IRA, with an additional $1,000 catch-up contribution allowed for workers 50 and older. Additionally, you may only contribute up to 100% of your income to a Roth IRA. So if your annual income is less than $6,500, you won’t be able to contribute the full amount.

SEP IRA vs. Solo 401(k)

A solo 401(k), also known as a one-participant 401(k), is another tax-advantaged retirement plan designed for business owners. It’s similar to a SEP IRA in many ways but also has some important differences.4

Availability

Both SEP IRAs and solo 401(k)s are available to business owners. However, SEP IRAs are available to businesses of all sizes and with any number of employees. Solo 401(k)s, on the other hand, are only available to business owners with no other employees, with the exception of a spouse.

Tax advantage

As we mentioned, SEP IRAs must be traditional IRAs, meaning contributions are made pre-tax, investment growth is tax-deferred, and distributions are subject to ordinary income taxes.

A solo 401(k) can accept either traditional or Roth contributions (or both). As a result, business owners can choose whether they want the tax benefit upfront or during retirement.

Contribution limits

SEP IRAs and solo 401(k)s have similar contribution limits, but they’re calculated differently. And the different calculation for solo 401(k)s could advantage certain business owners more.

As we mentioned, SEP IRA contributions are limited to the lesser of $66,000 or 25% of income. However, all contributions are made by the business, not the individual.

With a solo 401(k), both the business and the individual can make contributions. In fact, the contribution limits are the same as those for other employer-sponsored retirement plans. Here are the limits on each type of contribution:

  • Employee contributions: $22,500 or 100% of earned income
  • Employer contributions: 25% of compensation
  • Total contributions: $66,000

For a self-employed individual earning less than $264,000, a solo 401(k) would allow for higher contributions than a SEP IRA. Technically the two have the same maximum limit: $66,000. They also both have the same 25% contribution limit for the business itself. But in the case of a solo 401(k), the business owners can contribute $22,500 on top of the 25% business contribution.

Additionally, business owners who are 50 or older may contribute an additional $7,500 to their Solo 401(k)s. As a result, the maximum contribution becomes $30,000 for the individual and $73,500 overall.

 

 

RO3133029-1023

1 IRS, “Simplified Employee Pension Plan (SEP),” December 2022.

2 IRS, “Simplified Employee Pension—Individual Retirement Accounts Contribution Agreement,” December 2004.

3 IRS, “Amount of Roth IRA Contributions That You Can Make For 2023,” August 2023.

4 IRS, “One-Participant 401(k) Plans,” August 2023.

Glossary Label
SEP IRA
Glossary Definition
A SEP IRA — short for simplified employee pension plan — is a tax-advantaged retirement plan designed for business owners. While it can be used by businesses of any size, it’s often used by small business owners and self-employed individuals.

The Currency editors

Staff contributors

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