What is a SEP IRA?

What is a SEP IRA?

What is a SEP IRA? Many people wonder about this. Ultimately, a SEP IRA (simplified employee pension plan) is like a traditional IRA used for small business owners and self-employed individuals.

Roughly 16.5 million people in America are self-employed, which can bring challenges and quirks for those planning for retirement. They cannot rely on the company or use a traditional or Roth IRA.

Instead of being unable to retire or having a low amount of funds, self-employed people can use other savings options, such as a SEP IRA. This differs from Roth IRAs in many ways, which you’ll learn about below. Likewise, we will discuss the purpose of the SEP IRA and offer the benefits and drawbacks.

Understanding SEP IRA

It’s important to have an individual retirement account, but if you’re self-employed, the options are slim. However, a simplified employee pension plan might be just what you need. Let’s learn what a SEP IRA is below! Should you wish to learn about IRAs in general, our article provides a detailed explanation of an IRA for anyone to understand.

sep stands for simplified employee pension

Definition of a SEP IRA

Many people get confused because of the mess of letters. However, this just makes it easier to write and say. Ultimately, the first part is “simplified employee pension,” and the second stands for individual retirement account.

SEP IRAs are basically individual retirement accounts, similar to a traditional IRA. With this simplified employee pension plan, business owners can make tax-deductible contributions. The investments will grow tax-deferred up to retirement, and then the distributions get taxed as income.

Ultimately, tax-advantaged retirement accounts like these aren’t available to small business owners. However, the SEP IRA allows people to plan for retirement. Therefore, it’s wise to establish a SEP IRA if possible.

Key Features of a SEP IRA

It’s important to understand the key features or basics of a SEP IRA. These include:

  • Make tax-deductible retirement contributions to a SEP IRA as a self-employed person.
  • Roth IRAs are available in SEP varieties, which use after-tax contributions.
  • Contribute either $66,000 in 2023 ($69,000 in 2024) or 25 percent of the income, whichever is lesser of the two.
  • You can easily open a SEP IRA with an account provider. They will put your money into mutual funds, money market funds, bonds, and other investments.
  • Employer contributions must be an equal percentage of compensation for every eligible employee.

How a SEP IRA Works

Ultimately, SEP IRAs are just employer-sponsored retirement plans that self-employed individuals and small business owners utilize for retirement purposes. Every business owner could open a SEP IRA to save for retirement, and they can also extend it to employees.

Any money contributed to the SEP IRA uses pre-tax dollars. However, the employer is the only one who can make contributions. Therefore, the business enjoys the upfront tax benefits instead of the employee. Likewise, money in the SEP IRA will grow tax-deferred. Whenever SEP IRA distributions are taken in retirement, they’re subjected to ordinary income taxes.

In a sense, SEP IRAs differ from other retirement accounts and plans because employees cannot contribute. Instead, the company must contribute money to each employee’s SEP IRA.

Another difference between this and other plans is that employees are 100 percent vested in the SEP IRA. If an employer makes the contribution for the employee, it solely belongs to the employee.

There is a catch with a SEP IRA, and many large employers choose not to use one because of it. Ultimately, equal contributions are a requirement for all employees.

Let’s say that you start up a business and want to put 10 percent of your salary into a SEP IRA. However, you then hire an employee. Because you have to contribute equally for everyone, you must reduce your contributions or contribute 10 percent of the employee’s wages into a SEP IRA for them.

As with other retirement accounts, the money contributed to the SEP IRA can be invested in various ways. Employees can decide for themselves, but investment options include stocks, mutual funds, bonds, money market funds, and ETFs (exchange-traded funds).

Benefits of a SEP IRA

There are many advantages of having a SEP IRA, which include:

  • Flexibility with Contributions – While you must contribute the same amount for every employee, you can pause or change SEP IRA contributions anytime you want.
  • Tax-deductible Contributions – Your business can deduct the SEP IRA contributions if you’re self-employed. They aren’t considered taxable income and also aren’t subjected to FICA taxes. Those who have employees can also get tax deductions when they make contributions to the employee’s account. You’d deduct the lesser of the contributions or 25 percent of the compensation. There is a compensation cap of $330,000 for 2023.
  • Ease of Administration and Setup – A SEP IRA is much easier to set up and maintain than other workplace retirement plans. Therefore, they’re more attractive for self-employed individuals.
  • Higher Contribution Limits – The maximum SEP IRA contribution is $69,000 in 2024 ($66,000 in 2023). This is much higher than contribution limits for a 401(k), and a traditional or Roth IRA.
  • Combine with Other IRAs – You can combine the SEP IRA with a traditional IRA but not a Roth IRA. Though there are special rules in place for this, it is possible. Overall, you could boost your retirement benefits by doing so.

Drawbacks of a SEP IRA

Though a SEP IRA has many advantages, there are some disadvantages to consider, such as:

  • Age Requirement and Minimum Distributions – SEP IRAs are subjected to RMDs (required minimum distributions). Therefore, you will have to start taking withdrawals at 73 and pay taxes on them. As with a traditional IRA, any distributions you take before 59.5 years old are taxed as income. If you withdraw early, you are subjected to a 10 percent penalty unless you have a reason that satisfies the early withdrawal exceptions listed by the IRS.
  • Required Proportional Contributions for All Eligible Employees – Business owners are required to contribute the same percentage of all wages and compensation to all the eligible employees. Therefore, if you contribute 10 percent of your wages, you must contribute 10 percent to all employees.
  • No Roth IRA Version – You must set up your SEP IRA as a traditional IRA. There is no Roth IRA option, which means you cannot benefit from tax-free distributions during retirement. However, one way around that is to complete a Roth IRA rollover later.
  • No Catch-up Contributions for Those 50 or Older – Though other tax-advantaged retirement accounts will offer higher contribution limits for older people, a SEP IRA doesn’t. Therefore, you can’t boost your retirement account savings if you open a SEP IRA later in life.

Setting Up a SEP IRA

Setting up your SEP IRA accounts can seem daunting, but it’s an easy process once you understand what to do. Here is the information you should know:

Who Can Establish a SEP IRA?

Technically, all business owners can set up SEP IRAs. They are easy to do and require equal contributions for every employee. Therefore, they’re typically used by self-employed individuals and small business owners who have few or no employees.

In a sense, you’re not technically required to have an established business to create a SEP IRA plan. Anyone with self-employed income can establish a SEP IRA, such as gig workers and freelancers who aren’t counted as employees.

Eligibility Criteria for Establishing a SEP IRA

If companies choose to offer employees SEP IRAs, the small business owners are allowed to set the minimum requirements that the employee should meet to be eligible. The employer decides whether to use restrictive or less restrictive eligibility requirements.

The IRS also has minimum eligibility requirements to open a SEP IRA, which pertains to small business owners and self-employed individuals. People must:

  • Receive $750 or more in compensation for 2023. In previous years, the numbers were $600 for 2019/2020 and $650 for 2021/2022.
  • Work for that employer for three of the last five years.
  • Be 21 years of age or older.

Steps to Set Up a SEP IRA

Setting up SEP IRAs for a business is a pretty easy process. That’s part of why this account type is so popular for self-employed individuals and small business owners.

Here are the steps involved in setting up SEP IRA accounts:

  1. Choose the Financial Institution – The institution you choose serves as the custodian or trustee of your SEP IRA and holds each employee’s assets for their retirement plans.
  2. Execute the Written Agreement – You are required to draft a written agreement and share it with your eligible employees. It should include the plan participation requirements and the employee’s name. The IRS offers a model SEP plan document for employers to use. It’s called Form 5305-SEP or the Individual Retirement Accounts Contribution Agreement for the Simplified Employee Pension.
  3. Give Your Employees the Information About SEP IRAs – You should tell your employees that you’ve established the plan, as well as how the contributions are allocated and the requirements for them to receive a contribution. Ultimately, your plan isn’t “adopted” until all the eligible employees receive information about it.

Timing and Deadlines for Setting Up a SEP IRA

You can pretty much set up a SEP IRA at any time. However, the deadline for any SEP IRA contributions is the tax day of the following year. For instance, employers may contribute to the SEP IRAs until the tax filing deadline in the 2023 tax year. Typically, this is on or near April 15 of the year following the contribution year. This means for 2023, the deadline would be April 18, 2024.

Those who file a tax extension can make contributions up until the end of that extension period.

Participating in a SEP IRA

As a self-employed individual, you can participate in a SEP IRA without worrying about other employees. However, if you own a small business, you will have to ensure everyone participates and receives equal compensation or percentages. Here are the rules to consider:

Eligibility Requirements for Employees

Eligible employees aren’t just people who work for you. In fact, you can be considered an employee if you get compensation from your business. Ultimately, you could contribute to the SEP IRA on your behalf. However, “employee” also includes leased employees and employees of other companies that you or your family own.

The eligibility requirements are as follows for an eligible employee:

  • Must be at least 21 years old
  • Has performed services for you for the last three of five years
  • Has earned $750 or more in compensation for 2023

The 3-of-5 Rule Explained

The 3-of-5 eligibility rule means that you must open a SEP IRA for any employee who has worked for you in any three of the past five years. However, the employee must satisfy other eligibility requirements you set up.

Exclusion Categories for Employees

Though you’re primarily required to include all employees in a SEP IRA, there are some exclusions. These include those who are:

  • Nonresident alien employees (no US source of income)
  • Covered by any union agreement if the retirement benefits had been bargained for in good faith by the employee’s union and you
  • Acquired employees during the transitional period only

Employee Benefits of a SEP IRA

Because the employer contributes to the SEP IRA for the employee, employees don’t have to worry about doing it themselves. In fact, they never really have to talk to the trustee or financial institution.

Though they can’t make contributions personally, this can be a perk because they don’t have to remember to do so. However, the money put into the account is not tax deductible for the employee. Only the employer gets the feature. Likewise, employees will count distributions as taxable income.

However, if you are the only employee and choose to set up your own SEP IRA, your business will get the tax-deferred feature, and you can claim it as a loss on your federal income tax return.

Likewise, SEP IRAs are easy to set up. As a self-employed individual, this means you can do it yourself without hiring an accountant or tax professional to help you. However, it’s always wise to speak with a financial advisor because investing involves risk, and you must know what is right for you.

Funding a SEP IRA

Whether you hope to invest in mutual funds or stocks, it’s easy to fund a SEP IRA. Here is the information you need:

Understanding SEP IRA Contributions

Employees are not allowed to make a SEP IRA contribution. SEP IRAs are funded solely by employer contributions. Likewise, employers can choose not to contribute to the SEP IRA in any given year and can set up the eligibility requirements they prefer. This provides more control for them.

SEP IRA Contribution Limits

With a traditional IRA, you can only contribute $6,500 (2023) or $7,000 (2024). However, those 50 or older can contribute $1,000 more in both years. Alternatively, a SEP IRA allows you to stockpile almost 10 times this amount at $66,000 (2023) or $69,000 (2024). However, SEP IRA contribution limits apply and can’t exceed the lesser of:

  • $66,000 in 2023 or $69,000 in 2024
  • 25 percent of the compensation

Ultimately, 25 percent of compensation is the limit for what you can contribute to each eligible employee. The compensation amount you use to calculate that 25 percent is just $330,000 (2023) and $345,000 (2024). Likewise, employer contributions must be made by the tax filing deadline or extension due date of the federal income tax return.

SEP IRAs also don’t offer catch-up contributions for those 50 or older.

Determining SEP Contributions for an Employee

During the 2023 year, employer contributions are limited to either $66,000 or 25 percent of the person’s compensation.

Let’s say an employee earned $264,000. The SEP IRA contributions could be the full $66,000 because that’s 25 percent of the employee’s compensation. However, if the person only made $100,000, the contribution limit is $25,000.

Though you have to make contributions to each employee, the amounts can vary significantly.

Determining SEP Contributions for a Self-Employed Individual

In a sense, the SEP employer contributions are the same for a self-employed individual because they are both the business owner and the eligible employee. Therefore, the same rules apply.

The contribution limits are 25 percent of the total compensation or $66,000 in 2023. Therefore, if you earned $100,000, you could only contribute $25,000, or 25 percent. Alternatively, those who earn $264,000 or more may contribute $66,000.

Rules for Making Contributions to a SEP IRA

Making Contributions to a SEP IRA

Usually, SEP IRAs are ideal for those who are self-employed and small business owners without employees (or few employees). If you have an employee, and the IRS considers them eligible participants in the plan, you are required to contribute on their behalf. Likewise, those contributions have to be an equal compensation percentage to your own.

The SEP IRA rules are as follows:

  • An eligible employee is someone who is 21 years of age or older. They must work for you for three out of five years and make a minimum amount of $750 (2023 and 2024). Therefore, if the employee worked for you during the years of 2021, 2020, and 2019 and earned $750 or more, you’ll have to make employer contributions for them during the 2023 and 2024 tax years.
  • If you wish to stash 15 percent of your compensation for your own retirement plan, you must contribute 15 percent of the employee’s compensation to a plan for them. This is simply an example; SEP IRAs feature the contribution limits talked about earlier. Likewise, you can choose a lower percentage; 25 percent is just the maximum contribution limit available.
  • Employees must own and be able to control their own SEP IRA accounts.

Managing a SEP IRA

Once you set up a SEP IRA account, it’s up to you to manage it yourself. However, employees under you can manage their own accounts. Here are a few things to be aware of:

Contribution Rules and Regulations

You are obligated to forward each SEP IRA contribution to the financial institution or trustee for any employees who participate. Likewise, you’re required to keep the financial institution aware of changes in the status for employees in the plan. For example, when you hire new employees, you’ll include them in the SEP IRA if they meet the eligibility criteria you’ve set forth.

Employer contributions to each employee’s SEP IRA plan for one year can’t exceed $66,000 in 2023 or 25 percent of that employee’s compensation for those last three years. The limits apply to the total contributions in that plan and other defined contribution plans, such as money-purchase plans, profit sharing, 403(b), 401(k), and other SEP IRAs.

It’s important to note that the contributions are only based on the first $330,000 in compensation for 2023. Since employees must work for you for three out of five years, you would go back to 2022, 2021, and 2020, using those numbers to calculate the contributions. These were:

  • $285,000 in 2020
  • $290,000 in 2021
  • $305,000 in 2022

The limits for those same years include either 25 percent of the employee’s compensation or:

  • $57,000 in 2020
  • $58,000 in 2021
  • $61,000 in 2022

Likewise, you aren’t required to contribute each year. However, when you do so, you must contribute to the SEP IRAs for all participants who did work for your business in the year for which those contributions get made. Be aware that this applies to participants who pass away or quit/get fired before those contributions are made.

Ultimately, the contributions to a participant’s SEP IRA must be uniform. This usually indicates the same percentage of compensation.

Ownership of SEP Contributions

Employers are required to set up SEP IRAs for every eligible employee with an insurance company, bank, or another qualified financial institution. However, the employee owns the SEP IRA and any contributions made by the employer. They can use this to buy mutual funds and other investment options, though they must do so through the SEP IRA holder.

Basic Withdrawal Rules

Typically, general rules for withdrawing from your IRA correlate for SEP IRA. Therefore, the owner can withdraw funds at any time, though there are general limitations. For example, the withdrawal is tax-deferred, so it’s taxable in the year it’s received. Plus, if participants make withdrawals before turning 59.5 years old, they will often get hit with a 10 percent penalty tax.

Rollovers and Distributions

Participants aren’t allowed to take loans from the SEP IRA account. However, they can withdraw funds at any time. That money could be rolled over (tax-free) into another SEP IRA, into a traditional IRA, or to be used in another qualified retirement plan (as long as that plan allows for rollovers).

Generally, rollovers only happen when you leave the employer. You will receive the funds from the SEP IRA and can put it into an existing or new one. Moving funds allows you to control and use the best investment strategy for your needs. There are three rollover options available:

  • Direct Rollover – Typically, the financial institution holding the SEP IRA will send you a check, but it’s usually payable only to the new account. You must then deposit that check directly into your new IRA to avoid tax liability.
  • 60-day Rollover – If you wish to have more control over your rollover process, the 60-day rollover option is ideal. This is where your financial institution will distribute the SEP IRA funds directly to you. It often withholds the taxes. Then, you have 60 days in which to deposit those funds into the new account to avoid penalties and other taxes. Because taxes are withheld, you’re responsible for making up that difference whenever you re-deposit the funds into the new account. You’re also limited to one 60-day rollover per year.
  • Trustee Transfers – If you don’t want to be involved in the transaction, you should consider a trustee-to-trustee transfer. The two financial institutions will partner together to complete your rollover. This helps you avoid tax liability.

If the money is withdrawn from the SEP IRA and isn’t rolled over into another plan, it’s subjected to income tax for the distribution year. If employees choose to withdraw funds from the SEP IRA before they’re 59.5 years old, an additional tax of 10 percent usually applies. This is called a tax penalty in most cases.

Similar to traditional IRAs, employees must start withdrawing specific minimum distributions from their SEP IRA accounts after they reach 72 years old and by April 1. Typically, they will be 73 when this happens, but it doesn’t always work that way.

After the initial year, they are required to withdraw additional required minimum distributions by December 31 of every year after that. In most cases, the trustee or financial institution will notify the employee by January 31 each year when they must take a minimum distribution.

Filing and Notice Requirements

If employees participate in a SEP IRA, they must get certain disclosure documents from the financial institution and the employer. These include:

  • You should provide employees with a copy of Form 5305-SEP and the instructions for use. However, you may have used a different method to establish the plan, and you’d supply that document. Whenever new employees are eligible to participate, they must receive the plan copy.
  • You’re required to provide written statements about the SEP IRA terms, how changes are to be made to the plan, and when the employees should get information about account contributions.
  • Along with the information above, your financial institution must issue an annual statement for every participant’s SEP IRA. This reports the account’s fair market value.
  • The financial institution must also offer participating employees a copy of their annual statement, which is filed with the IRS. It contains fair market value and contribution information.
  • Usually, if an employee participates in the plan and receives distributions from the account, the financial institution will send a copy of Form 1099-R to them.
  • The financial institution often notifies the employee by January 31 if a minimum distribution is needed.

Typically, SEP IRAs don’t have to file annual financial reports to the Federal Government. The contributions aren’t included on the W-2, either.

However, the trustee or financial institution handling the SEP IRA will give the IRS and employee an annual statement with various information. It’s called Form 5498.

Correcting and Avoiding SEP IRA Errors

After you open a SEP IRA for yourself and your employees, it’s important to maintain each one and watch for errors. Learn more about the most common mistakes, the consequences involved, and how to avoid and correct them below:

Common Mistakes in Operating a SEP IRA

Here is a list of the most common mistakes when operating a SEP IRA:

  • You didn’t update the SEP plan document for the current rules.
  • Employees related to your business weren’t allowed to participate.
  • Eligible employees accidentally got excluded from participating.
  • The contributions to the SEP IRAs for participating employees were miscalculated.
  • The contributions to each SEP IRA weren’t uniform percentages of that participant’s compensation.
  • Contributions to your SEP IRA exceeded the maximum contribution limits.

higher tax penalties in sep ira

Consequences of Making a Mistake

In most cases, you will lose your tax benefits if you don’t meet the requirements or make a mistake. However, the IRS does allow you to make corrections. This might mean you must pay taxes.

For example, if you exceed the maximum contribution amount and leave it for too long, that overage is subjected to a six percent tax on every employee’s IRA. Likewise, the employer might be subjected to a 10 percent excise tax on the extra non-deductible contributions.

Steps to Correct Errors

If you have made an error, you should work to fix it as soon as possible. Ultimately, here are the steps to take:

  • If you didn’t update the SEP plan document for the current year, you should make sure you’re using the most recent version of Form 5305-SEP. Those who aren’t should adopt the revised Form 5305-SEP.
  • If you didn’t include employees related to the business, identify the companies you own or have a financial relationship with. Create SEP IRAs for those employees, contributing the amounts they should have received.
  • If you exclude eligible employees from participating in the SEP, make sure you review your plan sections for participation and eligibility. Check for updates when you hire new employees. To fix the problem, make sure you create a SEP IRA for those employees and use corrective contribution to put them in the right position if there hadn’t been an operational plan mistake.
  • If you miscalculated the contributions for participating employees, make sure you review your SEP plan to determine which compensation amounts you should use. To fix the mistake, you’d have to recalculate the contributions, removing or adding amounts as needed.
  • If you didn’t use a uniform percentage of compensation for each participant, you would have to add or remove funds from the SEP IRA to put the employee in the position they’d have been in if you hadn’t made a mistake.
  • If you exceeded the maximum contribution limits for a SEP IRA, you would have to determine the contributions made for every employee. Make sure those amounts don’t go over 25 percent of their compensation of the dollar limitation ($66,000 in 2023). You would then have to retain the extra amount or distribute it to other accounts as needed.

Preventing Errors in SEP IRA Management

Ultimately, it’s better to prevent errors when managing your employee’s SEP IRAs. Here are the ways to do this for specific situations:

  • Maintain contact with the company you used to create your SEP plan document. It should notify you of changes, but you may have to “opt-in” for such a service.
  • Make sure you know if you own other businesses to avoid excluding employees from participating.
  • Once a year, make sure that you review each employee’s participation status to avoid excluding eligible employees from participating in the SEP IRA.
  • Review your SEP plan document terms to make sure you’re using the right compensation amount when you calculate contributions. Understand the definition of compensation for your situation and needs.
  • After you have initially calculated the allocations for contributions based on your SEP plan documents, verify that the proposed contributions are using the uniform percentage for participant compensation levels.
  • Once you initially calculate the allocations for contributions based on the SEP plan document terms, check to ensure that none of them would potentially violate the law.
  • Familiarize yourself with the IRS SEP Fix-It Guide, which is found at www.irs.gov/ep. It will help you avoid common mistakes or fix them if you notice them.

Ending a SEP IRA

Sometimes, you’ll need to end SEP IRAs for certain employees or yourself. Learn more about why you’d do that, how to complete the task, and what notification requirements you may have below.

Reasons for Terminating a SEP IRA

SEP IRAs are primarily established to continue indefinitely. However, business owners might find a time when it no longer suits their purposes or needs. Here are the reasons you might terminate a SEP IRA:

  • The employee no longer works for the company (fired or quit).
  • The employee wishes to roll over the SEP IRA into another retirement account.
  • The employer no longer wants to contribute to the SEP IRA or chooses another option for retirement benefits.

Steps to Terminate a SEP IRA

Business owners will generally find it easy to terminate a SEP IRA. The steps include:

  • Notify the financial institution of the SEP IRA that you’re no longer contributing and wish to terminate the agreement or contract. This must be done in writing.
  • You’re not required to notify the employees that you’re discontinuing the plan, though it is a good idea to do so.
  • You don’t have to give notice to the IRS that you’ve terminated the SEP plan.

Notification Requirements When a SEP Terminates

When business owners decide to terminate SEP IRAs, the notification requirements include:

  • Tell the financial institution that you don’t wish to contribute anymore and will terminate the agreement or contract.

This is the only notification requirement involved for terminating a SEP IRA. However, it’s wise to tell the employees about the change or discontinuation of the plan.

SEP IRA versus Other Retirement Plans

Many times, business owners have to decide between SEP IRAs and other types of IRA. If you’re in this boat, here are a few things to consider:

SEP IRA vs. Individual 401(k)

An individual 401(k) is sometimes called a one-participant or solo 401(k). This is a great tax-advantaged retirement plan for business owners, and it’s similar to the SEP IRA in many ways. However, there are a few important differences.

Typically, both solo 401(k)s and SEP IRAs are available to self-employed people and business owners. However, companies of any size and with limitless employees can use a SEP IRA. On the other hand, solo 401(k)s are available solely to business owners without employees (other than a spouse).

SEP IRAs are traditional IRAs, so the contributions use pre-tax dollars. Likewise, they enjoy tax-deferred investment growth, and the distributions are subjected to ordinary income taxes.

However, a solo 401(k) could accept Roth and traditional contributions (or both). Therefore, company owners can decide whether they want their tax benefits upfront or in retirement.

Ultimately, a SEP IRA and solo 401(k) feature similar contribution limits, though they’re calculated at different rates. SEP IRA contributions have limits of 25 percent of the income or $66,000, whichever is less. However, the contributions get made by the business instead of the individual.

In a solo 401(k), the individual and business can contribute, and the contribution limits are similar for other retirement plans sponsored by the employer. Here are the limitations:

  • Total Contributions – $66,000
  • Employer Contributions – 25 percent of compensation
  • Employee Contributions – 100 percent of earned income or $22,500

Self-employed people who earn less than $264,000 will get higher contributions in a solo 401(k) than in a SEP IRA. Technically, both have the same maximum limit of $66,000 and have the 25 percent contribution limit from the business. However, in a solo 401(k), the business owner can contribute up to $22,500 on top of that 25 percent business contribution.

Likewise, those who are 50 years or older can contribute $7,500 in additional funds with a solo 401(k), so the maximum contribution is $30,000 for an individual or $73,500 total.

employee benefits of sep ira

SEP IRA vs. Traditional IRA

A SEP IRA is one type of traditional IRA, but they have different rules in place. Generally, you open a traditional IRA through your preferred financial institution, making contributions each year. However, SEP IRAs are primarily for self-employed people and small business owners with/without employees.

With a simplified employee pension plan, the employer is the only one who can contribute, and employees must meet certain criteria to participate. This includes:

  • Earning $750 or more in that tax year
  • Being employed by the same employer during the last three of five years
  • Being 21 years old or older

Ultimately, the requirements to set up a traditional IRA are less strict. There are no age requirements or income thresholds. Likewise, you can earn income from tips, a salary, or wages, though passive income will not count.

The contribution limits are also different for both a SEP IRA and a traditional IRA. With a SEP IRA, the employer decides what to contribute to the account. However, if there are employees, each one must receive the same compensation percentage. For 2023, you can contribute $66,000 or 25 percent of the employee’s salary.

Likewise, employees can’t make contributions from their income; the employer does that. They can determine when to contribute and how much up to the annual limit.

If you have a traditional IRA, you contribute to the account from your own income stream. However, the annual contributions are limited to just $7,000 if you’re under 50. Those over 50 have the catch-up contribution, which is $1,000 more. This isn’t available in a SEP IRA.

Retirement accounts are beneficial because of the tax advantages for earnings, withdrawals, and contributions. Traditional and SEP IRAs are tax-deferred retirement accounts.

In a SEP IRA, contributions are a tax deduction for the employer. However, the employee won’t receive deductions for any contributions made for them. They get the tax advantage with the tax-deferred growth of the earnings within the account.

Alternatively, a traditional IRA allows you to deduct any contributions you made on your personal income tax return. This often lowers the taxable income for that year. Plus, you see tax-deferred growth and are only taxed when you take distributions.

SEP IRA vs. Roth IRA

Both a SEP IRA and a Roth IRA offer tax benefits upon retirement. The main difference between them is that SEP IRAs provide tax-deferred growth on the investments, and Roth IRAs offer tax-free withdrawals during retirement.

The contributions made to SEP IRAs are actually tax deductible. However, you cannot deduct contributions from your Roth IRA since you paid taxes on that money already before it went into the account.

Likewise, you can include your employees in a SEP IRA, making the contributions for them. That’s not possible with Roth IRAs, which is why SEP IRAs might be best for self-employed individuals.

Overall, SEP IRAs offer higher contribution limits of up to $66,000 for 2023 and $69,000 for 2024. A Roth IRA only allows $6,500 for 2023 and $7,000 for 2024. Ultimately, both accounts might be suitable for a business owner. However, they each have different tax advantages. Plus, SEP IRAs might be ideal for companies with many employees.

Choosing the Right Retirement Plan

It can be challenging to choose the right retirement savings plan for your needs. Here are a few things to help you decide if a simplified employee pension plan is ideal or if you should go with a Roth or traditional IRA:

  • Tax Breaks – A Roth IRA sees tax breaks when withdrawing funds, though SEP and traditional IRAs get tax breaks on the pre-tax income (only the employer for a SEP IRA).
  • Required Minimum Distributions – Roth IRAs don’t require RMDs, though traditional and SEP IRAs do.
  • Annual Contributions – A SEP IRA is the lesser of $66,000 (2023) or 25 percent of compensation. Roth and traditional IRAs have annual contribution amounts of $6,500 (2023) plus $1,000 more if you’re over age 50.
  • Taxation – In a Roth IRA, the money is taxed as income before it’s contributed. However, the opposite applies for traditional and SEP IRAs (the withdrawals are taxed as income).
  • Eligibility for Deductions – Deductions are allowed up to the contribution limit for SEP IRAs. However, traditional and Roth IRAs could be reduced if the person makes more than the threshold.

Ultimately, self-employed people and small business owners typically use SEP IRAs. However, traditional and Roth IRAs are used by any person with a taxable income.

Frequently Asked Questions About SEP IRAs

Can I Contribute Different Amounts for Different Employees in a SEP IRA?

No. The IRS regulations for SEP IRAs require employers to contribute an equal amount to each eligible employee’s account. However, this is based on a percentage of compensation in most cases, so the amounts might vary.

For example, if one employee earns $100,000, they would get a contribution of $25,000. However, if another employee earned $264,000, they would receive $66,000.

Can I Withdraw Money from a SEP IRA Before I Retire?

With a simplified employee pension plan, you can withdraw money from it before you retire. However, you will be taxed on the distributions. If you’re under 59.5 years old, there are 10 percent penalty fees for SEP IRAs, as with traditional ones.

What Are the Tax Implications of a SEP IRA?

SEP IRAs offer tax benefits for both parties. The employer’s contributions are tax deductible for them; the employee doesn’t see any tax deduction. However, their money grows tax-deferred and is taxed when withdrawn.

Though you can take money out of the SEP IRA at any time, you will generally see a 10 percent penalty fee if you do so before 59.5 years old.

Can I Have a SEP IRA and a Traditional IRA at the Same Time?

The government doesn’t put restrictions on contributing to a SEP and traditional IRA within the same year. Likewise, you aren’t required to reduce the SEP IRA contribution to make traditional IRA contributions.

However, a traditional IRA does come with income limits for deducting contributions. In fact, you can only get the full deduction on your traditional IRA if your income was less than $73,000 (2023) or $76,500 (2024).

Let’s say you exceed the income limit and can’t get a traditional IRA deduction. In that case, you might decide to roll the funds from the traditional IRA into a Roth IRA with a rollover method. If you do this, you’ll benefit from tax-free distributions if you wait until retirement age.

Still, the catch here is that the government requires rollovers from a traditional to a Roth IRA to be done pro rata. If your SEP IRA account contribution is $56,000, and you have a non-deductible traditional IRA contribution of $6,000, you can’t simply roll over that $6,000.

If you roll over the $6,000, which is 9.7 percent of the $62,000 total, the government treats it like you rolled over $5,418 of your SEP and $582 of the non-deductible traditional IRA (both figures are 9.7 percent). Unfortunately, you can’t designate which dollars get rolled over.

Overall, the only way you can roll over your full non-deductible amount to a Roth IRA would be to actually roll over all your traditional assets, including the full value of any other IRA accounts.

What Happens if I Make Excess Contributions to My SEP IRA?

Any excess contributions made to SEP IRAs are included in the employee’s gross income. If you withdraw the excess contribution and any earnings before the due date of your federal return, you can avoid the six percent excise tax penalty.

However, if the employee leaves the excess contributions in the SEP IRA after the due date of the federal return, they are subjected to the six percent tax. Likewise, the employer might have to pay a 10 percent excise tax on any extra non-deductible contributions. It’s possible to correct this mistake, but it might cost you if it’s been a while since it was made.


If you are self-employed and want to contribute to your own tax-advantaged retirement plan, the SEP IRA might be a great choice for you. It allows you to contribute more than traditional and Roth IRAs every year. As with a traditional IRA, the savings will grow tax-deferred, though you probably won’t see tax-free growth like you would with a Roth IRA.

Generally, people choose SEP IRAs when they don’t have other employees. However, it can work for small businesses that have many employees.

Ultimately, it’s important to understand the SEP IRA rules before you set one up. Therefore, you should talk with a professional financial advisor to determine what is right for you and your retirement plan.

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