What Is a SEP IRA and How Does It Work?  (2024)

For solo entrepreneurs or small-business owners looking for a no-fuss way to save for retirement, a SEP IRA may be the ticket.

A SEP IRA is essentially a traditional IRA for people who run their own businesses and can afford to save more for retirement than other IRAs allow. It’s simple to administer and offers a double tax benefit: Tax-deductible contributions mean lower taxable income now and taxes on gains are deferred until retirement.

Setting up and contributing to a SEP IRA is straightforward for a self-employed person with no employees, says Kaylin Dillon, a certified financial planner in Lawrence, Kan. Business owners can set aside up to $69,000 of earned income in 2024—nearly 10 times the $7,000 that can be saved in regular IRAs this year.

Here’s what to know about SEP IRAs, from tax rules to who they’re best for.

What is a SEP IRA?

A SEP, or simplified employee pension, is a retirement plan for self-employed people and business owners. It permits, but generally doesn’t require, contributions to individual retirement accounts—called SEP IRAs—for the employer and eligible employees.

As with a 401(k) or traditional IRA, investments in a SEP IRA grow tax-free and ordinary income taxes are due on withdrawals after age 59½ (early withdrawals incur a penalty, with a few exceptions). Unlike with a 401(k), the employer has no additional tax paperwork to file, and there is minimal record-keeping. “As far as anything in the tax code goes, it’s about as simple as it gets,” says Dillon.

However, business owners with employees may find SEP IRAs difficult to manage, as they’re required to contribute to the accounts of all eligible workers at the same rate that they contribute to their own.

“That can add up quickly when you have employees,” says Eliot Bassin, a tax and business advisor at Fiondella, Milone & LaSaracina, an accounting firm in Connecticut.

Who can open and contribute to a SEP IRA?

Anyone who files business taxes as a sole proprietor, partnership or S-corporation can establish a SEP and then open IRAs for all employees. SEP IRAs can be set up at a bank, brokerage or robo advisor.

Employers are only required to make SEP IRA contributions for workers when they contribute to their own account—and then they must contribute an equal share of each person’s compensation. For example, a business owner who earns $200,000 and wants to save $25,000 in their own SEP IRA must contribute the same percentage (12.5%) of each eligible employee’s annual pay to their SEP IRA. So an employee earning $75,000 would get an employer contribution of $9,375.

An eligible employee is typically someone who is at least 21 years old, worked for the company for at least three of the past five years and earned $750 or more in compensation in 2023 or 2024. Business owners can be less restrictive, though, and opt for no age requirement or allow employees to join the plan after just one year of service, for instance.

Workers cannot contribute to SEP IRAs on their own and shouldn’t rely on employer contributions to build retirement savings, since future contributions aren’t guaranteed. However, unlike employer matching in a 401(k), which often requires a vesting period, employees immediately have full ownership and control over the money contributed to a SEP IRA on their behalf, just as if it were a traditional IRA.

What are the SEP IRA contribution limits?

The most an employer can contribute to an employee account is 25% of their annual pay, up to $69,000. (The limit adjusts each year for inflation, it was $66,000 in 2023.) That means an employee would need to earn $276,000 to be eligible for the maximum contribution this year.

Those who file as sole proprietors and single-member LLCs have to do a more complex calculation to find their maximum contribution rate (the dollar limit is also $69,000). Fidelity has a worksheet you can use to figure your exact contribution if you’re self-employed. But generally the contribution rate ends up at around 20% of your self-employment income after adjusting for the self-employment tax deduction and SEP IRA deduction.

Employers should take care not to overfund SEP IRAs. Any contributions made over the legal limit for an employee will be included in the employee’s income and potentially subject to a 6% tax on the contributions and earnings if not corrected.

Are SEP IRA contributions tax deductible?

Businesses with employees can deduct contributions they make to SEP IRAs, limited to the lesser of total contributions or 25% of total employee compensation (capped at $345,000 of annual compensation per person).

For example, say a business owner contributes 20% of pay to SEP IRAs for three employees who earn $50,000, $75,000 and $110,000. The employer’s total contribution is $47,000, while 25% of the employees’ combined compensation is $58,750. The lower number is the employer’s deduction.

Self-employed people need to use an IRS worksheet—or hire an accountant—to calculate the deduction they get for their own SEP IRA contributions.

Employees receiving SEP IRA contributions can also save up to the annual limit in other IRAs. Traditional IRA contributions are generally tax deductible, but receiving SEP IRA contributions from your employer might affect how much you can deduct. The deduction is reduced for those participating in an employer-sponsored retirement plan, including a SEP IRA, who meet certain income thresholds.

What is the contribution deadline for a SEP IRA?

While some expenses have to be paid by the end of the calendar year to be eligible for a tax deduction when you file—examples include charitable donations and mortgage interest—for retirement plans, there is extra time.

SEP IRA employer contributions generally must be made by the federal tax filing deadline. That’s April 15 for sole proprietors and March 15 for multiple-member partnerships and S-corporations. If you file for an extension, you have until Oct. 15 to make SEP IRA contributions and claim the deduction on your tax return.

Employees who receive SEP IRA contributions can file as they normally would. The brokerage managing the SEP IRAs will send Form 5498 to each employee for informational purposes. Employees don’t need to report anything on their tax return unless they took a distribution from the account.

What are the rules for withdrawing from a SEP IRA account?

Contributions to SEP IRAs are considered pretax, so investment gains are shielded from taxes until withdrawn, at which point they’re subject to ordinary income taxes.

Withdrawals taken earlier than age 59½ trigger a 10% penalty, which can be waived in certain situations, such as for a first-time home purchase (up to $10,000), qualified higher education expenses, adoption expenses (up to $5,000) or health insurance premiums while the account owner is unemployed.

When you turn 73, you need to start withdrawing a minimum amount each year from your SEP and traditional IRAs. The required minimum distribution, or RMD, rule also applies to 401(k)s and 403(b)s.

RMDs are calculated by taking your eligible account balances and dividing by a life expectancy factor provided by the IRS. “The SEP IRA is going to be included in that mix to determine how much you have to take out each year for your RMDs,” Bassin says.

Like traditional IRAs, a SEP IRA can also be converted to a Roth IRA. You pay income taxes on the balance at the time of conversion and are left with a pot of tax-free money to draw on in retirement. A benefit of Roth IRAs is that they don’t mandate annual withdrawals.

What makes a SEP IRA unique and who is it best for?

Self-employed people with few or no employees will get the most out of a SEP IRA. “If your spouse works with you, then a SEP IRA could be a good choice, especially if it’s just the two of you in the business because then it does dramatically increase the amount that could be saved,” Dillon says. If one spouse has a second job and participates in their company retirement plan—a 401(k), for instance—they would still be eligible for a SEP IRA.

SEP IRAs can get expensive if you have to cover additional employees’ retirement savings, because your savings are limited by the amount you can afford to save for everyone. “If you’re anticipating that you’re going to bring on employees fairly quickly, a SEP may not be the best alternative because you’re solely responsible for funding those contributions,” Bassin says.

What is the difference between a traditional IRA and a SEP IRA?

SEP IRAs and traditional IRAs have the same investment and withdrawal rules, but differ when it comes to who can contribute and how much.

Employers set up and fund SEP IRAs on behalf of employees, with an annual maximum contribution of $69,000 in 2024. By contrast, traditional IRAs are opened and funded solely by individuals, who can save up to $7,000 across their accounts in 2024 (or $8,000 if they’re 50 or older).

Contributions to a traditional IRA may be tax deductible for the individual, while contributions to a SEP IRA are tax deductible for the business owner. In other words, the contributor gets the tax break.

What is the difference between a 401(k) and a SEP IRA?

401(k)s are often associated with corporate jobs, but self-employed people can set them up too. Single-participant 401(k)s, or solo 401(k)s, are for business owners with no employees other than their spouse. They are able to contribute pretax money to the 401(k) as both the employee and the employer, with varying limits for each role, totaling $69,000 per person, a year. Like a SEP IRA, investments in a solo 401(k) grow tax deferred and withdrawals are taxed as ordinary income.

A 401(k) could be well suited for a more established business that is able to save more than 25% of their earned income, Dillon says. “One of the main arguments for the solo 401(k) is that you can actually save at an even higher rate than the SEP IRA,” she says.

However, there’s more administrative work involved with operating a solo 401(k). When your balance reaches $250,000 or more, you are generally required to file an annual tax form. No such tax filing exists for SEP IRAs.

What is the difference between a Simple IRA and a SEP IRA?

A Simple IRA—for Savings Incentive Match Plan for Employees of Small Employers—is a retirement plan for businesses with fewer than 100 employees, while SEP IRAs are for any size business.

Workers are permitted to contribute to their own accounts and the employer is required to contribute. It can either match employee contributions or contribute a flat 2% of compensation to each eligible employee’s IRA.

“That’s immediately an additional level of complexity. It requires tracking and you will need a plan administrator to help you track those things and make sure you’re following the rules,” Dillon says.

Employees and owners can elect to defer up to $16,000 from their paychecks to their Simple IRA in 2024, plus an extra $3,500 catch-up contribution if they’re 50 or older. However, if an employee participates in any other retirement plans funded by salary deferrals, their aggregate contribution limit across all employer-sponsored accounts is $23,000, not including catch-ups.

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