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.
SEP IRA vs. Traditional IRA
A SEP IRA and a traditional IRA overlap in a few notable ways.
- Both SEP IRA and IRA contributions are made with pre-tax dollars.
- Earnings are taxed when account owners make withdrawals.
- Both accounts impose a 10% penalty if funds are withdrawn before the account owner has turned 59 ½.
- 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.
- The maximum annual contribution to a SEP IRA is $58,000 in 2021, compared to $6,000 for a traditional IRA.
- A traditional IRA allows for an additional $1,000 catch-up contribution for individuals 50 or older. There’s no catch-up contribution for a SEP IRA.
- Only business owners may open SEP IRAs. Sole proprietors and self-employed individuals are eligible, but employees of companies without SEP IRA plans are not eligible to open these accounts individually.
- With a traditional IRA, you’re not obligated to contribute to anyone else’s plan.
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.
SEP IRA vs. Roth IRA
A SEP IRA and a Roth IRA have quite a few differences.
- Contributions to Roth IRA accounts are made with post-tax dollars, but withdrawals taken after age 59 ½, including earnings, are tax-free.
- A Roth IRA does not have any required minimum distributions.
- A Roth IRA has the same maximum annual contribution as a traditional IRA ($6,000) and offers the option to make a $1,000 catch-up contribution if investors are 50 or older.
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.
SEP IRA vs. 401(k)
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).
- Solo 401(k)s are only available to sole proprietors (single-person businesses). They’re not available to business owners who have employees.
- Solo 401(k) participants can make catch-up contributions up to $6,500 a year if they’re 50 or older.
- The account owner can borrow up to half the value of a solo 401(k) or $50,000, whichever is less.
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:
- Employees may contribute to their 401(k) regardless of employer contributions. Employees are usually not allowed to contribute to their SEP IRA.
- The employer may set up matching contributions to employee accounts, but is not obligated to make them. However, if an employer makes contributions to any employee’s account—such as the owner’s—they must make them for all.
- A traditional 401(k) requires more paperwork than a SEP IRA does, such as annual IRS filings and payroll deductions.
- The annual contribution limit for the account holder is $19,500 in 2021.
How to open a SEP IRA
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.
The bottom line
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.
