Simplified Employee Pension (SEP) IRAs: How Do They Work?

September 23, 2021
  • A Simplified Employee Pension (SEP) IRA is a retirement plan that business owners and self-employed persons can establish.
  • Employers can contribute 25% of an employee's annual compensation to a SEP IRA, or $58,000 for 2021, whichever is less.
  • SEP IRA contributions can only be made by employers, and the amount must be equal for all workers.
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When it comes to saving for retirement, there are several retirement accounts to choose from. Each has its own rules regarding contribution limits, distribution, rollover, and investment options.

If you own a business, are self-employed, or are earning freelance income, a Simplified Employee Pension (SEP) IRA is a retirement savings plan that can help you boost the size of your nest egg.

What is a SEP IRA?

A SEP IRA is a retirement savings account, much like a traditional IRA, that business owners and self-employed individuals can establish. This plan lets employers create and contribute to a SEP IRA for themselves and all eligible employees. Investments in a SEP IRA grow tax-deferred until withdrawn in retirement.

Unlike other retirement accounts, such as traditional IRA, SEP IRAs have higher contribution limits. This provides an opportunity to set aside more than what you could in employer-sponsored retirement plans.

How SEP IRAs work

SEP IRA works like traditional IRAs when it comes to rollovers, distribution, and investing options. Employers make contributions to SEP IRA accounts, which are tax deductible. The invested funds grow tax-free until withdrawn in retirement, which is then taxed as ordinary income. Employers must make equal contributions to their eligible employee's SEP IRA accounts.

Funds in a SEP IRA can be invested in various ways. Your investment options can depend on your age, planned retirement age, and risk tolerance. The employer is not responsible for making investment decisions. Instead, the individual account owners make investment decisions, and the company owning the invested funds figures out eligible investments.

It's important to note that not all employers can offer SEP IRAs. "Generally speaking, private sector [and] government entities cannot establish SEP IRAs," says Scott Steiner, Certified Financial Planner and senior financial planning specialist at Calamos Wealth Management. And in some cases, a SEP IRA may not be an ideal option for a business with many employees because it can be costly.

SEP IRAs also offer immediate vesting for employees. "SEP IRAs are always immediately vested, which means 100% of the account belongs to the employee," says Chirag Chauhan, Certified Financial Planner and financial advisor at Bluff City Advisory. "SEP IRAs have no vesting schedule, which is a plus for the employee."

Taxation

Similar to traditional IRAs, contributions made to SEP IRA grow tax-deferred until withdrawn in retirement. When you withdraw funds in retirement, they're taxed as ordinary income. Later, employees are eligible to withdraw the funds from their SEP IRA after age 59 ½. While you can take distributions from your SEP IRA anytime, early withdrawals incur a 10% tax penalty in addition to ordinary income tax. The required minimum tax distribution begins once you turn age 72.

Contribution limits

Employers can contribute the lesser of 25% of the employees' annual compensation or $58,000 toward SEP IRA. The compensation limit for business owners to be allowed to set up a SEP IRA is $290,000 in 2021.

Contributions made to a SEP IRA must be equal for all employees. For example, if an employer contributes 20% of an employee A's salary toward a SEP IRA, the employer must contribute the same percentage to all other employees. "But the employer can change the contribution percentage each year, and can even opt to pause contributions one year; for instance, if the company is struggling financially," Chirag says.

If you're self-employed and making SEP IRA contributions, the limits are similar to those of employees. Still, you must calculate the contributions for yourself using a special rule provided by the IRS. Notably, you can only make contributions in cash.

Eligibility requirements

In order to be eligible for a SEP IRA, you must:

  • Be 21 years old
  • Have worked for your employer or have been self-employed at least three of the previous five calendar years
  • Have earned a minimum of $650 in compensation during the current year

However, an employer may choose to exclude employees from a SEP if:

  • An employee has not earned any compensation from the employer
  • An employee is covered by a union and their retirement benefits were bargained for by a union

An employer can choose to be less restrictive on the eligibility requirements than those listed above, provided they do not create more restrictive ones than the IRS rules.

Pros and cons of a SEP IRA

Like any other financial product, SEP IRA has benefits and drawbacks.

The financial takeaway

The ability to save pre-tax money and set up a retirement plan for your business and employees makes it an appealing option for many sole proprietors and small business owners. A SEP IRA has higher contribution limits and allows you to invest in various assets, which can vary by trustee.

A SEP IRA is a great retirement savings plan for self-employed people and small businesses with few employees. The plan allows you to set aside a considerable amount of money per year toward your retirement. Plus, the funds grow tax-deferred until withdrawn in retirement. If you still need more information about SEP IRAs, consider talking to a tax professional or financial advisor.