Skip to Content
Learn/All About Investing

Simplified Employee Pension Plan (SEP) IRA: What Is It?

We’ll explain crucial details about Simplified Employee Pension plans, or SEP-IRAs. Learn essential rules for contributions and withdrawals.

Small business owners and self-employed individuals face unique challenges when planning for retirement.

This is where a Simplified Employee Pension (SEP) plan can help. SEP-IRAs are a type of IRA designed to cater to the retirement needs of small business owners. In this guide, we’ll walk through the crucial details of SEP-IRAs, exploring their features, rules, and benefits.

What’s an SEP-IRA?

An SEP-IRA is a retirement savings plan designed for small business owners and self-employed individuals. It operates as an employer-sponsored retirement plan that lets employers contribute to their employees’ retirement accounts—often with a portion of the employee’s income. If you’re self-employed, you can use an SEP-IRA to contribute to your own account.

These contributions are tax-deductible for the employer and grow tax-deferred until they are withdrawn by the employee during retirement. At that point, withdrawals are taxed as ordinary income. 

SEP-IRA Rules

SEP IRAs come with precise rules regarding withdrawals, eligibility, and contribution limits. Here are the essentials:

SEP-IRA withdrawal rules

Although contributions made to SEP-IRAs grow tax-deferred until distribution, any withdrawals made before age 59 ½ may be subject to a 10% early withdrawal penalty in addition to regular income tax. However, there are exceptions to this penalty when using the funds for certain qualified expenses, including higher education fees, purchasing a first home, or in case of disability.

Once account holders reach 72, they must take minimum distributions from their SEP-IRA, known as required minimum distributions (RMDs). The RMD amount is determined by the account balance and life expectancy factors. An account holder who fails to take an RMD in time may incur a hefty penalty.

SEP-IRA eligibility criteria

Eligibility for establishing and participating in an SEP-IRA primarily depends on the employer and employee status.

Employers who can establish an SEP-IRA include sole proprietors, partnerships, corporations, and nonprofit organizations. As of 2024, employers must offer the plan to all eligible employees who are at least 21 years old, have worked for the employer for three of the last five years, and have earned at least $650 during the year.

Employees are eligible if they meet the age and income requirements set by an employer with an established SEP-IRA. The SEP-IRA rules do not impose income limits on eligible employees, making them particularly attractive for high-earning individuals.

SEP-IRA contribution limits

Contribution limits for SEP-IRAs are determined by a formula that considers both the employer’s contributions and the employee’s elective deferrals. As of 2024, employers can contribute up to 25% of an eligible employee’s compensation or $69,000, whichever is less.

The calculation is slightly different for self-employed individuals, such as sole proprietors or independent contractors. It’s based on net earnings from self-employment, which is reduced by half of the self-employment tax and contributions made to the SEP-IRA. The maximum contribution limit for self-employed individuals in 2024 is also $69,000.

Unlike traditional IRAs or 401(k) plans, employees do not contribute to their SEP-IRAs through elective deferrals. Instead, all contributions come from the employer. 

Advantages of SEP-IRAs

There are many crucial SEP-IRA pros and cons to consider. Here are some of the positives:

  • Higher contribution limits: SEP-IRAs allow employers and employees to contribute a significant portion of their income—up to 25% of compensation or $69,000 (as of 2024), whichever is less. This allows for substantial retirement savings.

  • Tax advantages: Employers can deduct contributions to SEP-IRAs as a business expense, reducing their taxable income. Additionally, contributions grow tax-deferred until withdrawal, allowing investments to compound over time.

  • Simplicity in administrative requirements: SEP-IRAs are known for their straightforward administrative requirements. Unlike some other retirement plans, there is minimal reporting and paperwork for employers. 

  • Flexibility in contributions: Employers have the flexibility to adjust their SEP-IRA contributions each year to suit their budget.

Disadvantages of SEP-IRAs

SEP-IRAs aren’t for everyone. Here are some potential downsides:

  • Mandatory employer contributions: Employers must contribute to SEP-IRAs for all eligible employees. This can be challenging during financial downturns or for businesses with numerous employees.

  • Limited flexibility for loans: SEP-IRAs do not permit loans, unlike some other retirement plans, such as 401(k)s. This means that employees cannot borrow against their SEP-IRA assets.

  • No Roth option: SEP-IRAs only allow for traditional, tax-deferred contributions; there is no Roth option available within an SEP-IRA. Contributions are made with pre-tax dollars, and withdrawals in retirement are subject to income tax.

  • Short window for contributions: Contributions to SEP-IRAs must be made within the tax year. If a business decides to set up an SEP-IRA toward the end of the year, it has a limited timeframe to make contributions.

Comparing traditional vs. Roth vs. SEP-IRAs

Individual retirement accounts come in various forms, each suited to different financial situations and retirement goals. Here are side-by-side comparisons of the most common types of IRA:

Traditional IRAs

A traditional IRA is a tax-deferred retirement account. Contributions to a traditional IRA may be tax-deductible.

  • Tax treatment: Contributions to a traditional IRA may be tax-deductible, and the earnings grow tax-deferred until withdrawals are made in retirement. Withdrawals are then taxed as ordinary income.

  • Eligibility: Traditional IRAs have no income limits for contributions.

  • Suitability: Traditional IRAs are suitable for those who want to lower their current tax liability through deductible contributions. They’re also suitable for individuals who anticipate being in a lower tax bracket in retirement.

Roth IRAs

A Roth IRA is a retirement savings account with unique tax advantages. Unlike a traditional IRA, it is funded with after-tax dollars.

  • Tax treatment: Contributions to a Roth IRA are not tax-deductible, but earnings and withdrawals in retirement are tax-free.

  • Eligibility: Roth IRAs have income limits that determine how much one can contribute. Higher-income individuals may be restricted.

  • Suitability: Roth IRAs are suitable for individuals who expect to be in a higher tax bracket in retirement or want tax-free withdrawals. They are also beneficial for those who want to avoid required minimum distributions (RMDs).

SEP-IRAs

A simplified employee pension plan IRA functions similarly to a traditional IRA, with some essential tweaks.

  • Eligibility: SEP-IRAs are primarily designed for self-employed individuals and small business owners. Roth and traditional IRAs are available to a wider range of individuals.

  • Contributions: SEP-IRAs typically allow for higher contribution limits than Roth and traditional IRAs. They’re ideal for those with significant self-employment income.

  • Tax treatment: SEP-IRAs offer tax-deferred growth, similar to traditional IRAs. Taxes aren’t due until the money is withdrawn in retirement.

  • RMDs: Like traditional IRAs, SEP-IRAs are subject to required minimum distributions (RMDs) once the account holder reaches age 72.

  • Employer contributions: SEP-IRAs allow employers to make contributions on behalf of employees, whereas Roth and traditional IRAs are primarily individual accounts.

  • Flexibility: Roth and traditional IRAs offer more flexibility regarding contributions. SEP-IRAs are designed for business-related contributions.

How to open an SEP-IRA

Follow these steps to open an SEP-IRA:

  1. Eligibility check: Ensure you meet the eligibility criteria for establishing an SEP-IRA, which includes being self-employed or a small business owner.

  2. Choose a financial institution: Select an institution or brokerage firm that offers SEP-IRAs. Consider fees, investment options, and customer service.

  3. Complete IRS Form 5305-SEP: Fill out IRS Form 5305-SEP, the adoption agreement for an SEP-IRA. This form outlines the rules and conditions of the plan.

  4. Establish accounts: Open SEP-IRAs for yourself and eligible employees. You’ll need your employees’ Social Security numbers and contact information.

  5. Make contributions: Determine the contribution amounts for yourself and eligible employees. Contributions are typically a percentage of compensation.

  6. Notify employees: Inform eligible employees about their participation in the SEP-IRA.

  7. File Form 5305-SEP with the IRS: The form should be submitted to the IRS by the tax filing deadline.

  8. Set up recordkeeping: Maintain accurate records of contributions and transactions related to the SEP-IRA to ensure IRS compliance.

  9. Consult a financial advisor: Consider consulting a financial advisor or tax professional to ensure your SEP-IRA is set up correctly.

Begin your retirement planning journey with Composer

Composer simplifies the complexities of retirement planning, empowering you to achieve the lifestyle you envision. Start planning your future today with Composer; click here to start your 14-day free trial.