Investing for a financially secure future is a major responsibility. But for small businesses, enrolling in a traditional retirement plan is often perceived as too costly or complex.
A SEP IRA offers an easy-to-manage, affordable solution for small-business owners and self-employed people. With a SEP, employer contributions are made directly to traditional IRAs established at a financial institution for the employer and each eligible employee.
SEP IRAs feature contribution limits nearly 10 times higher than those of traditional IRAs, and employers are required to make contributions on behalf of their employees.
Contributions are tax-deductible, and investments are tax-deferred until retirement, when withdrawals are taxed as income.
Benefits include flexibility, high contribution limits and tax perks.
What Is a SEP IRA?
A SEP IRA is a written plan that allows employers to make contributions toward their own retirement and their employees’ retirement. It prevents employers from getting involved in a more complex qualified plan.
SEP IRAs can be attractive for small business owners because they are relatively simple to maintain and require less intensive reporting than some other retirement savings plans.
Flexibility is a major feature of SEP IRAs. These accounts do not require employers to make contributions each year. If the business doesn’t perform well, the employer can decrease their contribution or even skip it altogether that year. But, if things rebound next year, the employer can fund the plan with a larger contribution.
While business owners are responsible for making contributions to each employee account, workers still own and maintain control over their individual investment portfolios and distribution of assets. This helps business owners limit their liability as plan sponsors.
Opening a SEP IRA account gives you access to an assortment of funds you can use to build your SEP IRA portfolio. Employees can control how they invest and may choose from various options, including:
- Mutual funds
- Target-date funds
- Exchange traded funds
Small businesses can establish an SEP IRA up to the tax-filing deadline, or later if the employer gets a six-month extension to file. After the SEP is established, employers generally do not have to file any documents with the government.
SEP Contribution Limits
SEPs share many features with traditional IRAs, but one of the most significant differences is their contribution limits. These limits are much higher for SEP IRAs than their traditional counterpart.
For example, in 2023, traditional and Roth IRA contributions cannot exceed $6,500 (or $7,500 for people 50 years and older). Compare that with a SEP IRA, which allows employers to make annual contributions of up to $61,000 or 25% of each employee’s compensation, whichever is less. To illustrate, if an employee earns $40,000 annually, their employer can contribute up to $10,000 to his or her SEP IRA in a single year.
Workers can create a SEP IRA for their self-employed business even if they already participate in an employer’s retirement plan at a second job.
In 2023, self-employed people can contribute up to 25% of their net self-employment earnings. Consult IRS worksheets and tables found in Pub. 560 to ensure you correctly calculate your self-employed plan contributions.
Who Is Eligible for a SEP IRA?
SEP IRAs are most often used by self-employed people, entrepreneurs and small-business owners with few employees.
Things can get complicated if you have more than a handful of employees. That’s because a SEP IRA requires you to contribute on behalf of your employees, and those contributions must be the same percentage as your own.
For example, if you want to save 10% of your pay for retirement, you must also contribute 10% of each employee’s compensation to his or her plan. If you make $70,000 a year, you can contribute $7,000 to your SEP IRA plan, but if your employee earns $40,000 a year, you must also contribute $4,000 to his or her plan.
An employee is eligible to participate if he or she is at least 21 years old and has worked for the company for three of the last five years. The employee must also receive at least $600 in compensation during the year.
Do You Pay Taxes on a SEP IRA?
You are generally not required to file annual financial reports with the federal government after a SEP IRA is established. Most of the tax rules for individual accounts within a SEP IRA are the same as those applied to traditional IRAs.
Typically, 100% of all employer contributions to a SEP IRA are tax-deductible for your small business.
Contributions to a SEP IRA account are made with pre-tax earnings, and all investments within the account grow tax-free.
Employees and employers can start withdrawing money from an account at 59.5 years old. The IRS levies a 10% tax penalty for early withdrawals, but there are exceptions to this penalty in certain circumstances, such as death or disability.
Once you turn 72 years old, you must begin making required minimum distributions from your account. The IRS calculates the amount of this minimum withdrawal based on how much money is in the account at the end of the year and the account owner’s life expectancy.
Employees can also roll over their SEP IRA funds into another qualified account, such as a traditional IRA, without facing tax penalties.
Solo 401(k) Plan vs. SEP IRA
A solo 401(k) plan is a somewhat new option designed exclusively for sole proprietors with a single employee — the owner. It can also apply to the owner’s spouse if he or she is the company’s only other employee.
A SEP IRA works for companies with a handful of employees, but a solo 401(k) plan may be better for one-person enterprises.
Solo 401(k) plans allow you to contribute to the account both as an employer (up to 25% of your compensation) and an employee (up to $19,500 in 2020). In 2020, the maximum amount you can contribute to a solo 401(k) plan is $57,000 if you are younger than age 50. This is similar to the SEP contribution maximum; however, you have the ability to save more money with a solo 401(k) than with a SEP IRA during the years when your compensation is lower.
Also, solo 401(k) plans allow participants aged 50 and older to contribute another $6,500 a year as a catch-up measure. So, if you waited to start saving for retirement and need to make up for lost time, a solo 401(k) may help get you there faster.
You can also take out a loan equal to the lesser of $50,000 or 50% of the solo 401(k) account balance. Per the CARES Act, starting March 27, 2020, for a 180 day period, if you are impacted by COVID-19, you can take the lessor of $100,000 or 100% of your balance. SEP IRAs do not offer loans.
A third option is selecting a solo Roth 401(k), which offers different tax treatment than a traditional 401(k). This can be a good option if you think your income and tax rate are lower now than they will be in retirement.
Looking for guaranteed income in retirement?
How to Set Up a SEP IRA
It’s relatively easy to establish a SEP IRA.
You can open one at almost any bank, mutual fund company or brokerage firm. If you have employees, this financial institution will serve as trustee of the SEP IRA and hold each worker’s retirement plan assets.
You will need to follow these three steps:
- Execute a written agreement to provide benefits to all eligible employees.
- Educate employees about the agreement.
- Set up an IRA account for each employee.
The written agreement must include your name, the requirements for employee participation, the signature of a responsible official and a set allocation formula.
You may be eligible for a tax credit of up to $500 per year for each of the first three years for the cost of starting a SEP IRA.
The IRS provides a model SEP document on its website, Form 5305-SEP. Alternatively, you can use a prototype document provided by a mutual fund, bank, or other qualified financial institution. Or you can create your own.
The financial institution is required to provide a plain-language explanation of any fees and commissions it imposes on SEP asset withdrawals. As the plan sponsor, you should monitor the financial institution to ensure it is doing everything it is required to do and that its fees are reasonable for the services it provides.
If you use Form 5305-SEP, you must give your employees a copy along with instructions. This includes requirements for receiving a distribution from the plan and under what conditions you will allocate contributions.
After you make your first contribution, you and your employees will receive a statement from the financial institution. You should continue to receive a statement each year after that.