Updated for 2024. The Simplified Employee Pension (SEP IRA) is a type of a traditional IRA adopted by self-employed small business owners (sole proprietors, partnerships, C and S corporations), and the self-employed. Unlike most types of retirement plans, the SEP IRA is funded by the employer. Here’s more on what a SEP IRA is, tax benefits, contribution limits, and important deadlines.
What is a SEP IRA?
A SEP IRA (Simplified Employee Pension Individual Retirement Account) is a type of retirement plan specifically designed for self-employed individuals and small business owners. This type of account allows eligible business owners to make tax-deductible contributions to a traditional IRA for their benefit as well as eligible employees.
The SEP IRA is a straightforward and cost-effective way for small business owners to save for retirement. Particularly for individuals doing consulting or freelance work on the side, this type of no-frills retirement plan gives the option to reduce your taxable income but no requirement to do so.
In addition, you can decide each year whether or not you wish to contribute to your SEP IRA. This is particularly helpful if your business income varies from year to year.
Who is an eligible employee?
An employer with one (e.g. you) or more employees can establish a SEP. Unlike a Solo 401(k) which cannot be adopted if the business has non-spouse employees, a SEP IRA can include employees. In fact, you must cover all eligible employees.
So who is an eligible employee?
According to the IRS, an eligible employee must meet three different requirements, for age, length of service, and earnings:
- Age: 21 or older
- Time: has worked for the employer in at least three of the last five years
- Compensation: earned at least $750 for 2023 and for 2024
A business can choose to make their eligibility requirements less stringent, but cannot be more restrictive than these provisions.
How much can you contribute to a SEP IRA?
The maximum contribution is the lesser of: 25% of W-2 earnings, 20% of net income if self-employed, or $69,000 in 2024.
Again, all eligible employees must be covered by the plan. So when SEP contributions are made, they must be done equally across all eligible participants. This can either be a flat dollar amount or equal percentage of compensation.
Employers can decide if they want to make an annual contribution and if so, the amount, up to the limits. But again, contributions can’t favor one participant over another. However, if the business owner is much more highly compensated compared to their eligible employees, setting contributions as a percentage of earnings could provide more benefit to the business owner within permissible limits.
Due to the eligibility requirements and rigid contribution rules, SEP IRAs are mostly used by business owners without employees.
Can I contribute to a SEP IRA if I have a retirement plan at work?
SEP IRA tax deduction
Using a SEP IRA can have tax benefits for business owners. For sole proprietors, the SEP contribution will represent an above-the-line deduction on your personal tax return. If your business is taxed as a C or S corporation, multi-member LLC, or partnership, SEP contributions are deductible business expenses. This reduces the company’s net taxable income, which reduces taxable income that flows through onto a K-1.
Other SEP IRA benefits:
- Easy and flexible to set up and fund: SEP IRAs are the most flexible type of retirement plan. SEPs can be set up as late as the business’ tax filing deadline, including extensions, and still count towards the previous calendar year. Employees can allocate their SEP IRA assets into various investment options, including ETFs and mutual funds depending on what the employer has made available in the plan.
- Administration: SEP IRAs are not subject to annual IRS filings.
- SEP funding amount: Contribution limits: the annual contribution limit is the lesser of 25% of W-2 earnings, or 20% of net income if self-employed, or $69,000 in 2024.
- Impact on other IRA contributions: Unless a SEP plan allows for employee contributions, employer contributions generally will not impact the ability to make annual additions to a traditional or Roth IRA, subject to annual limitations and income thresholds for tax-deductible and Roth contributions.
- New Roth SEP IRA: The Secure Act 2.0 made it possible for employers to offer after-tax Roth SEP IRA funding if the employee elects. These regulations are still new so questions remain that require IRS guidance. Given the additional administration and reporting for employers, it’s unclear how many will choose to adopt.
Possible drawbacks to the SEP IRA:
- No loan provisions: because SEP IRAs have the same rules as Traditional IRAs, loans are not available.
- Contribution limits may be lower: given the availability of the elective deferral and catch-up contribution, some business owners may be able to save more using a Solo 401(k) plan than a SEP IRA. This will vary on an individual basis.
- Employees may want flexibility in saving for their retirement: Business owners with employees may find a traditional 401(k) or SIMPLE IRA is a better option to attract and retain employees. Since only employers fund a SEP IRA, there’s no tax benefit for the employee or guarantee the employer will make a contribution each year.
Other types of small business retirement plans to consider
The SEP IRA isn’t the only game in town. And depending on your business, income, company structure, and goals, it might not be the best solution for you. Here are some other small business retirement plans to consider:
SIMPLE 401(k) or SIMPLE IRA
- Good news: employees can elect to make deferrals, so the plan isn’t 100% employer-funded; less administrative burden compared to a regular 401(k) plan
- Possible drawbacks: employer contributions are required; lower deferral limits versus a traditional 401(k) and in some situations, SEP IRA
Solo 401(k)
- Good news: maximum deferrals for a business owner and their spouse, including optional employer contributions and individual participant deferrals (pre-tax or Roth); much less administration than a traditional 401(k)
- Possible drawbacks: business cannot have employees, other than a spouse
How to open a SEP IRA
Establishing a SEP IRA is a relatively simple process. Here’s how you can set up a SEP IRA:
- Choose a custodian: You can set up a SEP IRA at any qualified financial institution. Make sure the investment options and services meet your needs.
- Complete the paperwork: To establish a SEP IRA, you will need to fill out a SEP IRA adoption agreement and a SEP IRA account application. If you’re working with a financial advisor, they can prepare the paperwork for you, otherwise, contact the financial institution.
- Fund the account: Contributions can be made at any time, but they must be completed by the tax filing deadline (including extensions) for the year. Typically, business owners will wait until the completion of the year and work with their CPA or tax advisor to calculate the maximum contribution.
- Provide information to employees: If you have eligible employees, you must inform them about the retirement plan. This includes providing a copy of the SEP IRA adoption agreement and a summary of the plan’s benefits and features.
Distributions and Withdrawals
When it comes to distributions and withdrawals from a SEP IRA, the rules are similar to those for traditional IRAs, including possible tax implications and penalties. If you withdraw funds before reaching age 59 1/2, income tax and a 10% early withdrawal penalty may apply.
You’ll be required to start taking minimum distributions (RMDs) from your SEP IRA when you reach RMD age*. These RMDs are calculated based on your life expectancy (per the IRS) and the balance in your account on 12/31 of the prior year.
Saving for retirement as a business owner and entrepreneur
As a business owner, you are always juggling multiple priorities. Especially early on, it may be difficult to even think about saving for retirement, as you’re probably putting everything back into your business. No matter how likely a liquidity event or profitability goal may seem on the horizon, another event is surely more probable: one day you will want to, or need to, retire.
*RMD age, or more officially, your required beginning date, is age 72 if you were born on or after 7/1/49 or in 1950; 73 if born between 1951 and 1958; 75 if born in 1960 or later. If you were born in 1959, there’s an issue with the writing of the law and federal guidance is needed to determine if the RBD is 73 or 75.
Last reviewed September 2024
