Table of Contents
What is a SEP IRA and how does it work?
SEP IRA rules
SEP IRA contribution limits
The pros and cons of a SEP IRA
SEP IRA vs. Traditional IRA
SEP IRA vs. Roth IRA
SEP IRA vs. 401(k)
How to open a SEP IRA
The bottom line
Oct 4, 2022
6 min read
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.
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.
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.
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:
If a business experiences a downturn, the employer can pause contributions, as long as that pause applies to all employees, including the owner.
Try Titan’s free Roth IRA Calculator to see how much your Roth IRA will give you in retirement.Learn More
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 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.
As with other retirement accounts, the following rules governing withdrawals should also be considered:
A SEP IRA and a traditional IRA overlap in a few notable ways.
You do not have to make withdrawals from either type of account until you turn 72.
A SEP IRA also differs in many ways from a traditional IRA.
Self-employed individuals can open both a SEP IRA and traditional IRA. The employer portion of SEP IRA contributions do not count against the traditional IRA’s maximum contribution limit. For business owners, any employee contribution to a SEP IRA permitted by the plan does reduce how much they can contribute to their other IRA accounts for the year.
A SEP IRA and a Roth IRA have quite a few differences.
Again, employees may have a SEP IRA and a Roth IRA. If they make their own contributions to the SEP IRA, however, the allowable Roth IRA contribution will be reduced. Business owners can either make an additional contribution (up to the $6,000 limit) to their SEP IRA, or contribute their eligible amount to a separate traditional or Roth IRA.
FYI: Try Titan’s free Roth IRA Calculator to project how much your Roth IRA will give you in retirement.
A SEP IRA and 401(k) are quite different. For individual business owners who want a retirement plan for themselves, the best comparison is between a SEP IRA and a solo 401(k).
For business owners with employees, a traditional 401(k) is also an option; though traditional 401(k) plans are typically considered to be better suited to businesses with more than a few employees. Here are the key differences between traditional 401(k) plans and SEP IRA plans:
Setting up a SEP IRA entails creating a written agreement with an IRS form or a plan document from a financial institution. Businesses with employees must share plan information with eligible staff, then set up their SEP IRA account. Note the employee, not the business, owns the SEP IRA account.
For some business owners, a SEP IRA offers the chance to save for retirement while receiving tax advantages in the near-term. Small businesses with employees should clearly understand their responsibilities for making contributions to all eligible staff members.
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