A SEP IRA is a type of tax-advantaged retirement account that is available to self-employed people or small business owners and their employees. Think of them as a cross between a 401(k) and an IRA. For self-employed people, a SEP IRA works much like a traditional IRA or Solo 401(k)—but with a higher contribution limit. If a business owner brings on employees, though, they will be obligated to offer them the same SEP IRA plan and make salary-proportional contributions as well.
What is a SEP IRA and how does it work?
The term SEP IRA stands for “simplified employee pension individual retirement account.” SEP IRAs offer tax-advantaged benefits like other retirement accounts but with different rules governing who qualifies and how much they can contribute.
SEP IRA rules
A SEP IRA may be opened by a self-employed individual, sole proprietor of a small business, or the owner of a small business with employees. Contributions are made with pre-tax dollars. Once the account holder reaches retirement age, they can start making withdrawals, which will be taxed as income. This is similar to a traditional IRA.
If a business owner has or hires full-time employees, then equal contributions by salary percentage must be made to every employee who qualifies. For instance, if the business owner contributes 15% of their salary to the SEP IRA, all employees must receive contributions that amount to 15% of their salaries, up to the annual contribution limit. This is similar to how a 401(k) plan works, except that the employee usually needs to make a contribution in order to have a dollar amount matched by the employer.
The IRS has three qualifying factors for eligible employees:
- Employees must be at least 21 years old.
- Employees must have worked at the company for any three of the past five years.
- Employees must earn at least $650 a year.
If a business experiences a downturn, the employer can pause contributions, as long as that pause applies to all employees, including the owner.
SEP IRA contribution limits
The IRS sets new SEP IRA contribution limits each year. These typically rise slightly to account for inflation and any increase in the cost of living. Each employee may receive SEP IRA contributions from their employer up to one of the following limits, whichever is less:
- Contributions are limited to 25% of the employee’s annual compensation.
- Contributions cannot exceed $58,000 for 2021.
Self-employed individuals may contribute up to 25% of their net income, with a maximum of $58,000 for 2021. On top of employer contributions, employees may make additional contributions to their SEP IRA account, if their plan allows this. Note that some SEP IRA plans only allow employer contributions, though.
The pros and cons of a SEP IRA
Pros:
- The SEP IRA contribution limit is higher than other IRAs.
- SEP IRAs may be used in conjunction with traditional and Roth IRAs.
- Employer contributions are tax-deductible, including those made to employees’ accounts.
- Employers may skip annual contributions, as long as they apply to all participants.
- SEP IRAs have lower administrative and set up costs than 401(k)s.
Cons:
- Business owners are obligated to make contributions for all eligible employees.
- There are no catch-up contributions for account holders nearing retirement age.
As with other retirement accounts, the following rules governing withdrawals should also be considered:
- Early withdrawals are subject to a 10% penalty, as well as taxes.
- Earnings are tax-deferred, so plan participants must pay taxes on future withdrawals.
- Required minimum distributions begin when account owners turn 72.
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