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Updated on Thursday, December 10, 2020
A Simplified Employee Pension (SEP) IRA is an individual retirement account (IRA) that is set up and funded by employers, including self-employed workers. Best for small businesses and sole proprietors, SEP IRAs offer business owners tax benefits alongside retirement savings.
Find out more about how SEP IRAs work and whether they’re right for you and your business.
- How do SEP IRAs work?
- Who can get a SEP IRA?
- SEP IRA contribution limits
- SEP IRA withdrawal rules
- How do I invest in a SEP IRA?
- SEP IRA vs. other retirement accounts
- Is a SEP IRA right for you?
How do SEP IRAs work?
SEP IRA plans can be established by businesses of all sizes for their employees, as well as by self-employed workers. Like traditional IRAs, they are investment accounts intended to help workers save for retirement. SEP IRAs are established by the employer (or self-employed worker), but each employee gets to choose and manage their own investments within the account.
For employees, SEP IRAs are a nice add-on to your retirement savings, especially since contributions don’t come out of your paycheck. Employees are always 100% vested in the money in their account. This means you don’t have to wait to have worked at your job for a certain amount of time to fully own the money in your SEP IRA.
For employers and self-employed individuals, there’s a double tax benefit on top of the retirement savings. While you’re making contributions, you get to reduce your taxable income since the deductions are tax-deductible. The investments inside the account also grow tax-deferred, so you don’t have to pay taxes on those earnings until you make withdrawals in retirement.
Employers may also appreciate the relative low operating cost and ease with which you can open a SEP IRA compared to other retirement accounts.
Who can get a SEP IRA?
Per the IRS, SEP IRA-eligible employees must the following requirements:
- Be at least 21 years old.
- Have worked for their employer in at least three of the last five years.
- Have received at least $600 in compensation from their employer during the year.
Employers can choose to loosen these requirements, but they cannot make them more restrictive. However, employers do have the authority to withhold SEP IRA eligibility from employees who are covered by a union agreement and whose retirement benefits were bargained by the union and employer, as well as from non-resident alien employees who do not have U.S. wages, salaries or compensation from the employer.
These eligibility requirements also extend to self-employed workers who can choose to open a SEP IRA for themselves. If you’re self-employed and have another job in which your employer also offers a SEP IRA, you can set up a SEP IRA at both jobs.
SEP IRA contribution limits
Unless you’re a self-employed individual, only your employer can contribute to your SEP IRA plan, and the money they contribute does not come out of your paycheck. In 2020, SEP IRA contributions cannot exceed the lesser of either 25% of your compensation or $57,000 ($58,000 for 2021). An employee’s compensation may reach up to $285,000 in 2020 ($290,000 in 2021) and still be considered to calculate the 25% limit. There are no catch-up contributions for SEP IRAs.
Employers must contribute equally to all eligible employees’ SEP IRA plans, but the percentages of those contributions can change from year to year, providing employers with some level of flexibility. Contributions must be made in cash and by the employer’s federal tax filing deadline. For the employer, SEP IRA contributions are tax-deductible.
As an employee, the contributions your employer makes to your SEP IRA plan don’t affect how much you can contribute to another IRA on your own. SEP IRA contributions also are not included in your gross income as an employee (unless they are excess contributions) and therefore are not taxable.
Self-employed SEP IRA contribution limits
Self-employed workers are held to the same contribution limits, where compensation is based on net profits. There are also differences when determining the maximum deductible contribution. For example, for the 2019 tax year, self-employed individuals’ maximum deductible contribution for SEP IRAs was 25% of all participants’ compensation. Self-employed workers can calculate their SEP IRA contribution limits here.
Sole proprietors who contribute to an SEP IRA can also take advantage of the double tax benefits. Earnings in a SEP IRA grow tax-deferred inside the account and contributions are tax-deductible.
SEP IRA withdrawal rules
You must start taking required minimum distributions (RMDs) from your SEP IRA starting at age 72 for those whose 70th birthday fell on or after July 1, 2019 (for 70th birthdays before that date, the RMD age is 70 ½).
However, you cannot withdraw funds before the age of 59 ½ without paying a 10% penalty on top of taxes for the withdrawal. Withdrawals may be made penalty-free for qualifying first-time home purchase and select college expenses.
When you do withdraw money during retirement, you will be taxed on those distributions based on your tax bracket at the time of withdrawal.
How do I invest in a SEP IRA?
For employees, your employer can only do so much to help you save for retirement. After your employer has set up your account and made their contributions, it’s up to you to invest the money.
Your exact investment options will depend on the institution your employer has picked for your SEP IRA. But since it’s a retirement account, make sure to diversify your investments among stocks and bonds across various industries to create a more balanced portfolio. Investing in exchange-traded funds (ETFs), or groups of investments, can help you do that more easily. This diversification will help mitigate risk and losses along the way.
If you’re younger and further away from your retirement, you have some room to be a riskier with your investments by investing in stocks, which tend to be more volatile. That way, if there is a downturn, those investments will have time to recover before you need to cash them in when you retire. If you’re closer to retirement, you’ll want to play it safer with more stable investments that will carry you through.
SEP IRA vs. other retirement accounts
Despite the potential tax benefits, a SEP IRA plan may not result in the best returns for a freelancer or sole proprietor.
Here’s how the contribution limits for a SEP IRA for a 40-year-old sole proprietor in tax year 2020 compare to those of other popular retirement plan options:
Self-employed net profit
SEP IRA maximum contribution
Solo 401(k) maximum contribution
SIMPLE IRA maximum contribution
Traditional IRA maximum contribution
SEP IRA vs. solo 401(k)
A solo 401(k) is just like a regular 401(k), just meant for sole proprietors and their spouse, if applicable. For sole proprietors, SEP IRAs and solo 401(k) plans operate pretty similarly. You contribute to both plans with your earned pretax money, and you can adjust your contribution percentage however you like. Earnings in both accounts grow tax-deferred, but you pay taxes on your withdrawals in retirement (unless you open a Roth solo 401(k) plan).
However, freelancers with a solo 401(k) can contribute as both employer and employee, which increases how much they can contribute each year significantly.
“If someone is self-employed, they could be limited in their SEP contribution,” said Ted Toal, a certified financial planner (CFP) and president at RCS Financial Planning in Annapolis, Md. “If they want to save more but the SEP formula doesn’t allow them to, they should instead look to open a solo 401(k).”
The exact outcome depends on your income and how much you wish to save. In nearly all cases in the table above, you’ll be able to save more with a solo 401(k), but you should confirm that’s the case for you. Only when you reach $300,000 in net profit, in this example, does the SEP IRA catch up to the solo 401(k) where they both max out.
SEP IRA vs. SIMPLE IRA
Small businesses with 100 employees or fewer may also consider a SIMPLE IRA as an option. Unlike SEP IRAs, employees may also contribute to SIMPLE IRAs. Employers may also make contributions of up to 3% of their employee’s compensation as an employer match or a flat 2% of the employee’s compensation.
You’ll see in the table above that SIMPLE IRA contribution limits for the 40-year-old sole proprietor in tax year 2020 dip below SEP IRA limits once you get into $100,000 net income territory. If you’re self-employed and you really want to maximize your savings in one of these IRAs, the SIMPLE IRA option will work if you net less income.
Business owners should also note that SIMPLE IRAs have higher income requirements for employees to be eligible. An employee must have earned at least $5,000 in compensation during any two years before the current year and expect to receive at least $5,000 during the current year to be eligible for a SIMPLE IRA.
SEP IRA vs. traditional IRA
For self-employed folks, you will still be funding a traditional IRA with your own earnings, but the plan isn’t connected to your business. Instead, you’ll have to contribute to the account on your own with after-tax dollars. Still, the funds inside the account will grow tax-free, and you’ll pay taxes on the withdrawals you make in retirement.
For 2020 and 2021, you can contribute up to $6,000 (or $7,000 if you’re age 50 or older) or your taxable compensation for the year, if it was less than $6,000 (or $7,000). Contributions to a traditional IRA aren’t tied to your income levels, unlike an SEP IRA, so you don’t get to contribute more to your traditional IRA the more money you make. You can open a traditional IRA as a supplementary retirement account alongside a SEP IRA if you’re maxing out your SEP IRA.
Is a SEP IRA right for you?
For regular employees, a SEP IRA plan is great, because the account’s contributions aren’t coming out of your own earned money as they do with a traditional 401(k) plan. They also still allow you to contribute to other IRAs that you set up for yourself.
For freelancers, a SEP IRA is one of the simplest retirement accounts to open. If it aligns with your income levels and you play it right, it may allow you to save enough to live comfortably during retirement.
That being said, if you’re a sole proprietor with modest income, you may find a SEP IRA is limiting in terms of its allowable contributions. In the short term, you can separately fund a Roth or traditional IRA for an additional $6,000 a year if you’re under the age of 50, or $7,000 if you’re 50 or older (as of 2020).
If you have grander savings aspirations, a solo 401(k) may be a better solution as it can allow for higher contributions. It’s also worth noting that solo 401(k) plans allow for catch-up contributions and loans, neither of which are possible with a SEP IRA. Remember, however, that you only can open a solo 401(k) if you’re a sole proprietor or your only employee is your spouse.