What Is a SEP IRA?

What Is a SEP IRA?

A SEP IRA is a tax-advantaged individual retirement account that lets business owners contribute toward their employees' retirement as well as their own. SEP IRA contributions are tax-deferred, which means business owners and self-employed people can deduct contributions on their tax returns. As with traditional IRA or 401(k) funds, SEP IRA distributions are taxable as regular income when you withdraw money in retirement.

SEP IRA Basics

Although a SEP IRA shares many of the same rules and features of a traditional IRA, setting up a SEP IRA is a bit more complicated than opening an IRA for yourself. Here are some basic rules for SEP IRA plans.

• You must open an individual SEP IRA account for each employee.
• All SEP IRA contributions are employer contributions. Employee contributions and matching is not allowed.
• The contribution rate must be the same for all eligible employees. For instance, if you contribute 25% of your income to your own SEP IRA, your employees receive 25% as well.
• Contributions can vary from year to year.
• Contributions for the year should be made by the company's tax filing deadline. There is usually no separate filing requirement for SEP IRA plans, however.

SEP IRA Contribution Limits

The maximum contribution to a SEP IRA in 2023 is $66,000 or 25% of compensation, whichever is less. Additionally, the maximum amount of compensation that may be considered is $330,000 in 2023. For the 2024 tax year, the SEP IRA contribution limit increases to $69,000, with a compensation limit of $345,000.

Contribution limits for SEP IRAs are higher than the limits of other types of IRAs available to business owners and self-employed people. For comparison, here are the 2024 contribution limits for four common types of IRAs for business owners:

Source: IRS

SEP IRA Rules

The IRS has detailed rules for setting up and maintaining SEP IRAs. Here's a bit more detail on how SEP IRAs work and whether or not they might be for you.

Who Can Establish a SEP?

Businesses of any size can set up a SEP IRA plan, including sole proprietors, partners, corporations and nonprofits. Self-employed business owners who serve as their own sole employee are eligible to establish a SEP.

Eligible Employees

Although employees may not set up their own SEP IRA plans, employers can set up plans for their eligible employees. Eligible employees include anyone who meets these IRS requirements:

• Age 21 or older
• Has worked for the employer for at least three of the past five years
• Is not covered by a union agreement
• Is not a nonresident employee without any U.S. source of wages, salaries or other compensation from you
• Has received at least $750 in compensation

Self-Employment Contributions

Your SEP IRA contribution can't exceed 25% of your compensation. As a self-employed person, your compensation is defined as your net earnings from self-employment, minus half of your self-employment tax and any contributions you've made to your own SEP IRA. Learn more about self-employment contributions in IRS Publication 560.

Tax Deductions for Contributions

Contributions to a SEP IRA are tax deductible, including contributions made to your employees' SEP IRA plans. However, the most you can deduct on your business tax return for employee contributions is the total amount of your contributions or 25% of compensation, whichever is less. Your employees can exclude contributions from their gross income; SEP IRA contributions also aren't subject to federal tax withholding, Social Security, Medicare and federal unemployment taxes.

Vesting

Contributions are always fully vested. This means you and your employees have access to the money in your SEP IRA accounts immediately.

Income Taxes on Distributions

You can withdraw your money at any time but will have to pay income taxes on it when you do, along with a 10% additional early withdrawal tax if you're under 59½ years of age.

SEP IRA Pros and Cons

Self-employed people can choose between different (sometimes simpler) types of IRAs to invest their money for retirement. On the other hand, business owners may want to consider more fully featured 401(k) plans. SEP IRAs occupy a sweet spot between bare-bones individual IRAs and more complicated 401(k)s. Here are a few pros and cons to consider.

SEP IRA Pros

• Higher contribution limits enable self-employed people, business owners and their employees an opportunity to save more toward retirement compared to traditional IRAs, Roth IRAs and SIMPLE IRAs.
• SEP IRAs have fewer complicated rules and filing requirements than many other employer-based retirement plans, such as 401(k)s. SEP IRAs are suited to sole proprietorships and small enterprises with a few employees.
• Contributions can change from year to year, giving you and your business a bit of flexibility when you need it—and an opportunity to boost contributions when your revenue supports it.

SEP IRA Cons

• No Roth option. Currently, SEP IRAs follow the same rules for deducting contributions and paying taxes on distributions as traditional IRAs. There is no Roth version of a SEP IRA.
• Employee contribution rates must be equal. This means you can't contribute 25% of your compensation but only 3% of your employees' pay.
• All contributions are employer contributions. Your employees can't contribute themselves, though they can open their own IRA or Roth IRA accounts to supplement their retirement savings.

How to Open a SEP IRA

If you want to set up a SEP IRA plan for yourself as a sole proprietor or for your business and employees, follow these three basic steps.

1. Adopt a formal written agreement, choosing one of these three options:
   • Complete and sign Form 5305-SEP to adopt an IRS model SEP.
   • Select an IRS-approved prototype SEP from your bank or financial institution
   • Create your own individually designed SEP plan document.
2. Provide each eligible employee with information about your SEP IRA plan.
3. Open a SEP-IRA for each eligible employee.

SEP IRA accounts are available through many brokerage firms, banks, credit unions and some insurance companies. Funds may be invested in a variety of stocks, bonds, mutual funds, cash and other investments.

Make sure you set up and fund your SEP IRA by the due date (including extensions) for your business' income taxes, so you can calculate and deduct contributions on your tax return. Contributions for future years are also due on tax day.

The Bottom Line

Whether your goal is to save toward your own retirement or help your employees reach their retirement goals, a SEP IRA offers an easy way to make tax-deductible contributions with high IRS contribution limits. For solo business owners and entrepreneurs who want to explore their retirement plan options, SEP IRAs may be worth a closer look.