Finding the right retirement plan for your business can take time and effort. There are many options—each with pros and cons—to consider before choosing the best plan for you. One retirement plan option available to business owners and self-employed individuals is the SEP IRA, or the Simplified Employee Pension plan. It allows you to save for retirement based on your earned income. If you have employees, it allows you to contribute to their retirement too.
Although the SEP IRA is a good, relatively low-cost and low-hassle retirement plan option for business owners, there are some rules to be aware of before you complete the setup process.
What is a SEP retirement plan?
The “SEP” in SEP IRA stands for Simplified Employee Pension plan. While any employer can establish a SEP, small business owners and self-employed individuals often use it to help them save more for retirement than other plans will allow.
A SEP IRA is a traditional individual retirement account with many of the same distribution, investment, rollover and withdrawal rules and requirements. However, unlike with a traditional IRA, SEP account holders can save much more for retirement because the SEP IRA contribution limits are much higher than other IRAs.
The IRS only allows employers to contribute to a SEP IRA—employee contributions are not allowed under this retirement plan.
Because SEP IRAs require employers to make all the contributions, this form of individual retirement account is generally best for the self-employed or small business owners with only a few employees. Since each employee must receive the same contribution percentage in their account, a SEP IRA may not make sense for businesses with multiple employees.
SEP IRA contributions are tax deductible for the business and are not considered part of an employee’s gross income. The contributions and interest grow tax-free until taken out in retirement, when the money will be taxed as regular income.
How does a Simplified Employee Pension plan work?
SEP IRAs are available to businesses of any size, including self-employed individuals. Unlike other retirement plan options, there are no filing requirements or expensive fees to maintain a SEP IRA. A defining feature of the SEP IRA is that employers must contribute the same percentage of compensation to all employee accounts, including their own, without exception.
Some retirement plans, like a 401(k), may require employees to work for the company for a set period before the employee is entitled to all employer contributions. This is called a “vesting schedule,” and the time required can differ from employer to employer. With a SEP IRA, employees are 100% vested from when the account is created. This means the employee always owns all the money in the account.
Like other individual retirement accounts, including traditional and Roth IRAs, SEP IRAs require account holders to be 59½ before making withdrawals. If an account holder needs to withdraw money before reaching that age, they’ll have to pay a 10% penalty plus regular taxes on the funds withdrawn. If an account holder leaves their job, they can roll over their SEP IRA into another qualified plan tax-free.
There are no catch-up contributions for those age 50 and older with a SEP IRA. In addition, participants can’t take a loan or use the account assets as collateral.
If the particular SEP IRA plan allows, employees can make non-SEP (i.e., traditional IRA) contributions to a SEP account up to the maximum limit the IRS allows. This amount can include catch-up contributions, but it will reduce the amount the account holder can contribute across all IRAs, including Roth accounts.
SEP retirement plan eligibility requirements
To participate in an SEP IRA, employees must be:
- At least 21 years old
- Have earned at least $750 in the last year from the employer
- Have worked at least three of the previous five years for the employer
However, the IRS allows business owners to implement less restrictive eligibility requirements. For example, a business can lower the minimum age or enable new employees to participate in the SEP IRA plan immediately upon hiring. But the company cannot make participating harder than the minimum requirements set out by the IRS.
SEP IRA contribution limits for 2023
One of the benefits of a SEP IRA is the amount that can be put away for retirement. In 2023, contributions to a SEP IRA cannot exceed the lesser of:
- 25% of an employee’s total compensation
- $66,000
Employers must consider compensation up to $330,000, and total contributions cannot exceed 25% of the employee’s salary. The same limits apply to self-employed individuals, although there are unique formulas developed by the IRS to determine what their total contribution can be.
Employers must make the same contributions, by percentage of salary, to each eligible employee’s account, including themselves. For example, suppose an employer wanted to contribute 25% of their earned income to their SEP IRA in 2023, up to the contribution limit. In that case, they must also contribute 25% of each employee’s salary to their individual accounts.
Employers must make all contributions by the due date (generally mid-April) of filing their business tax return for the year unless they file for an extension.
Pros and cons of SEP retirement plans
Pros
- It’s easy to set up. The SEP IRA has relatively easy setup requirements. It also doesn’t require any ongoing reporting like a 401(k) or other larger retirement plan may require.
- It has low admin costs. Because the administration burden is relatively low, SEP IRA plans don’t have ongoing administrative fees beyond the cost of maintaining the accounts themselves at the brokerage.
- The account has high contribution limits. The SEP IRA has one of the highest 2023 contribution limits of any retirement plan. The 25% of income or $66,000 contribution limit is significantly more than a traditional or Roth IRA contribution limit.
- The contribution amounts are flexible. The rules allow employers to change contribution amounts from year to year. They can even decide not to contribute in a given year, which may be helpful if cash flow becomes an issue. Employers must inform employees of their contributions by Jan. 31 of the following year.
Cons
- Employers have to contribute equally. One of the reasons SEP IRAs are a great retirement plan for self-employed people is the equal contribution requirement for all employees. When you’re self-employed or only have a small business you and your spouse run, you can save as much as you want, up to the contribution limits, without worrying about making contributions to employees.
- It has required minimum distributions. Like with traditional IRAs, SEP IRA holders need to start taking required minimum distributions (RMDs) from the account when they reach age 73.
- There are no catch-up contributions. Unlike other individual retirement accounts, SEP IRAs don’t allow for catch-up contributions for those age 50 and older.
- A Roth option can be offered, but it’s not mandatory. Previously, all SEP contributions had to be made pre-tax. However, Section 601 of the SECURE Act 2.0 now allows employers to offer employees the ability to treat SEP contributions as Roth. (Note: The IRS hasn’t released any rules pertaining to this SECURE Act 2.0 change.)
SEP IRA versus traditional and Roth IRAs
SEP retirement plans have a lot in common with traditional and Roth IRAs. In fact, SEP IRAs can be traditional or Roth, just with different contribution rules.
While traditional and Roth IRAs are funded by the account owner, the SEP IRA is only funded by employer contributions, even though the employee owns the retirement plan account. Both accounts follow the same investment and withdrawal rules. Traditional and SEP IRA account holders have to pay taxes on both the principal and the interest when withdrawing money in retirement, while the Roth options are funded with after-tax dollars. This means account holders won’t pay taxes on withdrawals in retirement because taxes were already paid on the money contributed to the account.
When it comes to contribution limits, traditional and Roth IRAs are limited to $6,500 in 2023 (or $7,500 if you’re over 50), spread across the different IRAs a person may have. Meanwhile, SEP IRAs have a 2023 contribution limit of $66,000, or 25% of an employee’s total compensation, up to $330,000, which is significantly more.
SEP IRA versus SIMPLE IRA
The Savings Incentive Match Plan for Employees (SIMPLE) IRA can be another helpful way for small business owners or the self-employed to save for retirement. SIMPLE IRAs are available to small businesses with fewer than 100 employees and are another easy and relatively low-cost retirement plan option.
Like the SEP IRA, a SIMPLE IRA also requires employer contributions based on rules outlined by the IRS. However, while the SEP IRA only accepts employer contributions, a SIMPLE IRA allows employees to contribute up to $15,500 in 2023 through elective paycheck deferrals. Those age 50 and older can contribute an additional $3,500 for catch-up contributions.
Bottom line
There are many plan options to choose from when saving for retirement, including the Simplified Employee Pension plan. The SEP IRA might not be a good retirement plan choice for businesses with multiple employees. However, its high contribution limits and low administration requirements make setting up an SEP IRA an excellent option for business owners who are looking to save aggressively for retirement.
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