What Is a SEP IRA?

When you work for an employer, they may offer a retirement plan for you to take advantage of. However, depending on where you work or what you do, this plan can differ, ranging from options like a 401(k) to a full-fledged pension plan. Another type is a SEP IRA, which is a type of individual retirement account (IRA) that allows employers to set money aside for their employees’ retirement.

Having a SEP IRA as part of your retirement plan can be very beneficial, especially if you’re self-employed. This article will break down the ins and outs of these plans, including how contributions work and what means an employer uses to grow the funds within the account. You’ll also learn how they differ from both traditional and Roth IRAs. Finally, we’ll outline where this type of employer-sponsored arrangement fits into your overall retirement plan.

How SEP IRAs Work

A simplified employee pension individual retirement arrangement (SEP IRA) is a type of IRA that allows business owners to save money for both their and their employees’ retirement. Unlike a typical IRA, which requires individuals to put money in themselves, employers are responsible for contributing to their employees’ accounts. Then, an employee may invest funds as they see fit.

On the employer side, establishing a SEP IRA plan is much simpler and less cost-intensive than other types of retirement plans, such as a 401(k) or pension. For the most part, you get to make the rules, including when and how often you make contributions. However, if there are employees involved, everyone must receive the same amount.

Once an employer contributes to a SEP IRA, the funds within grow tax-deferred. This means that once you’re ready to withdraw money, you must pay income taxes at your rate. At the age of 59.5 years old, you may make qualified withdrawals. Be aware that, once you turn 73, you must make required minimum distributions (RMDs).

For an employee (including you if you’re self-employed) to be eligible to participate in a SEP IRA, they must typically meet the following requirements:

• Be at least 21 years old.
• Earned at least $750 in compensation from the employer in 2023 ($650 for 2022 and 2021).
• Have worked for the employer for three out of the last five years.

Contribution Limits

Unlike a traditional or Roth IRA, in which an individual deposits money, SEP IRAs require the employer to contribute. There are, however, rules for employers to follow when they add money to an employee’s account. Contributions may not:

• Exceed 25% of an employee’s compensation
• Be more than $69,000 in 2024 or $66,000 for 2023

With a SEP IRA, contributions are not deferred from an employee’s pay. Rather, the employer wholly funds these, much like a typical pension plan.

For self-employed individuals, the calculation for contributions is a bit different. Compensation equates to net earnings of the business, rather than simply what you pay yourself. Additionally, you’re able to deduct one-half of your self-employment tax (estimated tax) and any contributions to your SEP IRA.

Some SEP IRA plans allow employees to also make traditional IRA distributions. As of 2024, one may contribute up to $7,000 of earned income if they’re eligible. In this case, you’ll also be able to make catch-up contributions of $8,000 if you’re over 50 years old.

SEP vs. Traditional IRA

The primary difference between a SEP and a traditional IRA is who contributes. With the latter, a person puts in a certain amount of their earned income each year, allowing them to save and invest within the account for retirement. However, the former gives employers the primary responsibility of contributing a percentage of one’s earnings.

Beyond contribution rules, the differences largely end there. SEP IRAs follow the same rules as a traditional IRA when it comes to:

• Investing within the account
• Distributions (RMDs start at age 73)
• Tax-deductible contributions
• Tax-deferred withdrawals

Pros and Cons

SEP IRAs can be very beneficial tools for business owners looking to establish a retirement plan for both them and any employees. They only need minimal set-up and allow pretty hefty contributions. However, there are some downsides you should be aware of, such as requiring minimum distributions at age 73 or not allowing catch-up contributions.

Below are the pros and cons of establishing and using a SEP IRA:

Pros

• Easy for employers to set up, requiring minimal administration
• Employers don’t need to contribute every year
• Allows for substantial contributions that account for a percentage of an employee’s earnings
• Contributions are tax-deductible

Cons

• In most cases, only the employer may contribute
• You must make RMDs starting at age 73
• SEP IRAs require you to contribute to all employees’ accounts equally
• Unlike other IRA types, SEP IRAs don’t allow catch-up contributions unless you add funds in a traditional capacity

How to Set an Account Up

Setting up a SEP IRA is a relatively simple process for employers and self-employed individuals. First, you must select a financial services company, namely a broker, that offers this type of account. Prominent examples include:

• Vanguard
• Charles Schwab
• Fidelity
• T. Rowe Price
• Merrill

Once you have a financial institution in mind, you must sign Form 5305-SEP, which is a written agreement with the U.S. Internal Revenue Service (IRS). This form includes the following:

• Employer name
• Employee participation/eligibility requirements
• A “definitive allocation formula”
• Signature from a responsible representative of the employer

Within the SEP IRA, you’ll be able to invest in securities made available by the financial institution you work with. This may include:

• Stocks
• Bonds
• Mutual funds
• Exchange-traded funds (ETFs)
• Real estate investment trusts (REITs)

Who Should Open a SEP IRA?

SEP IRAs, unlike Roth or traditional IRAs, are built specifically for business owners and their employees. They provide a simple, easy-to-set-up way to establish a flexible retirement plan. For self-employed individuals or small businesses with employees, this can be an attractive option.

One of the key draws of SEP IRAs is that they’re flexible and require little administration. For instance, you don’t need to contribute to it every year. On the other hand, if you do contribute and have employees, everyone must receive equal benefits. This can be a challenge if you have a large business. Based on this, self-employed individuals and small businesses in need of an easy-to-manage retirement plan would likely benefit most.

Frequently Asked Questions

How much can I contribute to a SEP IRA?

If you’re an employer, you can contribute the smaller of $69,000 in 2024 or 25% of an employee’s compensation to their account. As a self-employed individual, your compensation is commensurate to your business’s net earnings.

In some cases, you may be able to make traditional IRA contributions to your SEP IRA. In 2024, this equates to a limit of $7,000 (or $8,000 if you’re 50 or over).

What is the downside of a SEP IRA?

SEP IRAs have a couple of downsides you should be aware of. First, only the employer typically contributes. This means that the employees of a company are at the mercy of their employer to receive any benefits. And, if the employer does contribute, all employees must receive an equal amount.

Is a SEP IRA pre-tax?

Yes, a SEP IRA uses pre-tax dollars to fund the account, meaning that you’re deferring tax payments until you make qualified withdrawals. Once you start making withdrawals, you will pay according to your bracket at that age.

Can you have a SEP IRA and a 401(k)?

It’s possible to have both a SEP IRA and a 401(k) for your retirement. You may have worked somewhere that offered one plan and then moved to another company. Or, you have a side business with a SEP IRA while working for an employer that offers the latter.

When can I withdraw money from a SEP IRA without penalty?

You may make qualified withdrawals from a SEP IRA once you turn 59.5 years old. And, at age 73, you’re required to make minimum distributions.