What is a SEP IRA?

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A SEP IRA (Simplified Employee Pension Individual Retirement Account) is a type of retirement account designed for self-employed individuals and small business owners in the United States. It allows employers to make tax-deductible contributions to their employees’ retirement accounts, including their own, offering a streamlined way for business owners to build retirement savings.

Anyone who participates in an SEP IRA must establish an IRA, and the contributions from the employer will be deposited into this IRA. With some financial institutions, the account will simply be labelled IRA, while others will label it SEP IRA before permitting any SEP IRA contributions.,

A SEP IRA is an excellent retirement savings tool for small business owners and self-employed individuals due to its high contribution limits, flexibility, and ease of setup. It’s a straightforward plan that allows for significant tax-deferred savings, providing a valuable way to plan for retirement. However, small business owners who are also employers should carefully consider the commitment to contribute the same percentage to all eligible employees and the absence of employee contributions before deciding if a SEP IRA is the right choice for their business.

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Key Features of a SEP IRA

High Contribution Limits
The most significant advantage of a SEP IRA over traditional or Roth IRAs is its high contribution limits. For 2024, an employer can contribute up to 25% of an employee’s compensation or a maximum of $66,000, whichever is lower. For self-employed individuals, the contribution limit is slightly reduced due to how compensation is calculated.
Employer-Funded
Unlike a 401(k), where both employers and employees can contribute, a SEP IRA is funded solely by the employer. This makes it an attractive option for business owners who want flexibility in deciding how much to contribute each year, depending on profitability. There will never be any employee-contrubutions to match.
No Annual Contribution Requirements
One of the benefits of a SEP IRA is that contributions are flexible. Employers aren’t required to contribute every year, which is ideal for businesses with fluctuating cash flow.
Equal Contributions For Each Employee The employer must contribute the same percentage of compensation for each eligible employee. As mentioned in point three, there are no annual contribution requirements, but if the employer does contribute, they must contribute the same percentage to each eligible employee.
Tax-Deductible For the Employer
Contributions made to a SEP IRA are tax-deductible for the employer, reducing taxable income for that year.
Tax-Deferred Growth The contributions grow tax-deferred, meaning you won’t pay taxes on the earnings until you withdraw the funds during retirement.
Administration The SEP IRA trustee (the financial institution where the IRA is kept) will send out annual statements and file the required documents with the IRS.

Who Can Set Up a SEP IRA?

The SEP IRA was created to encourage businesses (including self-employed individuals) who would otherwise not establish employer-sponsored retirement plans to do so. With that said, the rules for who can set up a SEP IRA are pretty flexible. A SEP IRA can be set up by any employer that fulfills the requirements, including self-employed individuals, sole proprietors, partnerships, and corporations – including S corporations.

Eligibility

Employers can impose less restrictive eligibility rules than the ones listed below, but cannot make them more stringent.

An employee is eligible when:

They are at least 21 years old, and
have worked for the employer in at least three of the last five years, and
have received at least $750 in compensation (as of 2024).

Excluding specific employees from the SEP IRA

If certain requirements are fulfilled, it is possible for an employer to exclude specific employees from participating in the SEP IRA even though they are otherwise eligible.

It is for instance permitted to exclude employees that are already covered by a union collective bargaining agreement for retirement benefits.

Another group of employees that can be excluded are thoses that are not U.S. residents and do not receive U.S. wages or other service compensation from the employer.

Income Limitations

There is a cap where having a salary above a certain limit makes you ineligible for participation in the SEP IRA. For 2024, this cap was $345,000.

Contribution Limitations for a SEP IRA

There are caps for how much the employer can contribute to an SEP IRA. The contributions are not permitted to exceed the lesser of 25% of employee compensation or $69,000 (in 2024).

For a sole proprietorship where the employee-owner is paying themselves wages, the SEP contribution is capped to 25% of wages or profits minus the SEP contribution.

Converting a SEP IRA to a Traditional IRA or to a Roth IRA

It is possible to roll a SEP IRA into a traditional IRA without owing taxes. In the eyes of the IRS, a SEP IRA and a traditional IRA are very similar account types, as they are both built by pre-tax dollars. During the rollover, the assets will be moved through a trustee-to-trustee direct transfer.

Rolling a SEP IRA into a Roth IRA is also possible, but it is a bit more complicated since the Roth IRA is built using post-tax dollars. Your ability to convert a SEP IRA into a Roth IRA will depend on several factors, including your income and your ability to pay the tax on the rollover. Rolling a SEP IRA into a Roth IRA is normally a taxable transfer. Note: If you use some of the rollover money to pay the tax, this can (depending on your age) trigger a penalty for early withdrawal. It is therefore best to use other money to pay the tax.

Rolling a SEP IRA to a Roth IRA will normally only make sense if you think you will be in a higher taxbracket during retirement than you are right now. Before you make any decision, please also consider the five-year rule for Roth IRA contributions, your own age and when you plan to retire.

Benefits of a SEP IRA

Simple to Set Up and Administer: SEP IRAs are easy to set up compared to other employer-sponsored retirement plans like 401(k)s. They involve minimal paperwork and administrative costs, making them ideal for small businesses that want a retirement savings plan without the complexity and high costs of other plans.
Flexibility: Contributions are flexible, which allows business owners to adjust contributions depending on their financial situation each year. In profitable years, employers can contribute more, and in leaner years, they can scale back or make no contributions. SEP IRAs have higher annual contribution limits than standard IRAs.
Self-Employed Contributions: For self-employed individuals, SEP IRAs are particularly beneficial. The ability to contribute up to 25% of net earnings, up to $66,000, provides an excellent opportunity to save for retirement at higher levels than with traditional or Roth IRAs.
No RMDs Until 73: Like traditional IRAs, SEP IRAs require Required Minimum Distributions (RMDs) starting at age 73. Before this age, there are no withdrawal requirements, allowing the account to grow tax-deferred.
Portability: SEP IRAs are fully portable, meaning that if employees leave the company, they can roll their SEP IRA balance into a traditional IRA or another retirement plan without tax penalties.

Drawbacks of a SEP IRA

Employer-Only Contributions: SEP IRAs don’t allow employees to contribute to their accounts. Only the employer can make contributions, which may be a drawback for employees who want to contribute more towards their retirement savings.
Equal Contribution Requirement: Employers must contribute the same percentage of income for all eligible employees, which can be a significant expense if the business has many employees. Business owners who want to reward higher earners or contribute more for themselves may find this restriction limiting.
No Catch-Up Contributions: Unlike traditional or Roth IRAs, SEP IRAs do not allow for catch-up contributions for those over 50. This can limit the amount older workers can contribute to their retirement savings.

SEP IRA vs. Other Common Retirement Accounts

SEP IRA vs. Traditional IRA: SEP IRAs allow for much higher contribution limits compared to a traditional IRA. While a traditional IRA has a maximum contribution limit of $7,000 for those 50 and older, a SEP IRA allows contributions of up to 25% of compensation or $66,000, making it more suitable for business owners with high income.
SEP IRA vs. Solo 401(k): A Solo 401(k) offers higher contribution limits for self-employed individuals because it allows both employee and employer contributions. With a Solo 401(k), you can contribute up to $23,000 as an employee (or $30,500 if you’re over 50), plus 25% of your business income as the employer, allowing for a larger total contribution.

Who Should Consider a SEP IRA?

Self-Employed Individuals: SEP IRAs are particularly appealing to self-employed individuals who want a simple, tax-efficient way to save for retirement.
Small Business Owners: Employers who want to offer a retirement plan to their employees without the complexity of a 401(k) might prefer a SEP IRA because of its simplicity and high contribution limits.
Businesses with Fluctuating Profits: Because SEP IRAs allow employers to contribute on a flexible basis, they’re ideal for businesses with inconsistent income. You can contribute more during profitable years and less (or nothing) in leaner years.

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