For the 16.5 million self-employed people in America, retirement planning can be challenging. Those who are self-employed can’t rely on their employer for retirement plans.

While contributing to a Traditional IRA or Roth IRA is an option, you can also boost your retirement savings by contributing to a SEP IRA. These retirement plans offer a lot of flexibility and a higher contribution limit. Read on to learn more about how they work and their pros and cons.

What Is a SEP IRA?

A Simplified Employee Pension Individual Retirement Account, or SEP IRA, is a tax-advantaged retirement plan for those who are self-employed, employ others, own a business, or earn a freelance income.

SEP IRA contributions are tax-deductible against any income earned or profits made during the year, any investment earnings inside the account grow tax-deferred (meaning any income and/or capital gains from the securities or other investment vehicles held inside the account are not taxed in the year they are earned), and the distributions are taxed as ordinary income in retirement.

How Does a SEP IRA Work?

The purpose of a SEP IRA is to help small business owners and self-employed individuals get tax-deferred benefits while they save for retirement. It’s an attractive option because employers can set it up to save for their own retirement at a higher level than traditional IRAs.  

[Quote by Brad Reichert:]  If the small business owner has any employees, s/he can also make tax-deductible contributions to SEP IRAs on behalf of these employees, similar to how a larger corporate employer makes a profit-sharing (or matching) contribution to an employee’s 401(k) account.  

It’s important to note, however, that employment-related contributions to SEP IRAs can only be funded by the business.  Employees are not allowed to defer a part of their salary or other annual pay into their SEP IRA.  

However, employees may be able to make Traditional IRA contributions to a SEP-IRA of up to $7,000 ($8,000 for employees age 50 or older) for the 2024 tax year.

[Reichert adds:]  The provisions of SECURE Act 2.0 allow employers with SEP IRA plans to offer the ability to set up Roth SEP IRAs and fund them with contributions, the same as Traditional SEP IRAs.  At this time, though, because the tax-deductibility of Traditional SEP IRA contributions makes them so attractive, very few employers are offering a Roth SEP IRA option as part of their employee benefits.

SEP IRAs are treated the same as traditional IRAs when it comes to tax treatment. When you make a contribution to a SEP IRA account as a self-employed worker or as an employer, you receive a tax deduction. Businesses aren’t locked into a contribution requirement. Whether you contribute and how much can change each year.

Contributions to the account are made with pre-tax dollars, and the money grows tax-free in the account. Once you reach the age of 59 ½, you can withdraw the funds from the account without a penalty. However, because the money contributed to the account and the earnings made inside of the account haven’t been taxed yet, you’ll have to pay income tax on withdrawals, no matter how old you are at the time you withdraw them.

Benefits of a SEP IRA

  • High contribution limit compared to other retirement plans, on par with employer-sponsored 401(k) or 403(b) plans.
  • Easy to set up and administer each year.
  • Fewer annual reporting and employee nondiscrimination testing requirements than 401(k) and 403(b) plans. 
  • Businesses don’t need to contribute every year.
  • Contributions are tax-deductible to the business or the self-employed individual.  
  • Employees do not need to include employer contributions in their taxable income for the year. As a result, SEP contributions are not subject to federal or state income tax withholding, no matter who makes the contribution–the employee or the employer.  
  • SEP contributions are not subject to social security, Medicare, and federal unemployment (FUTA) taxes, either.
  • Once deposited into a SEP IRA account, contributions are always immediately 100% vested or owned by the employee. 
  • SEP IRA contributions can be combined with (i.e., in addition to) contributions to a Roth IRA or traditional IRA at the personal level.

Drawbacks of a SEP IRA

  • Thanks to the provisions of SECURE Act 2.0, there is a Roth version of the SEP IRA, which allows you to make contributions with after-tax money and then get potentially tax-free distributions when you retire. However, these are not widely available from most employers because the employer does not get a tax deduction for contributions to Roth SEP IRA accounts.
  • No “catch-up” contributions are allowed for SEP IRA owners of any age.
  • Distributions before age 59 ½ are subject to penalty and are taxed as income.
  • If you contribute for yourself, you must also contribute to every eligible employee at the same % of salary rate.  For example, if the business owner contributed 8% of income to his/her SEP IRA, s/he must contribute 8% of income to all employees of the business, as well. 
  • SEP IRA contributions must be made in cash only. A business cannot make contributions in the form of company stock (if the company is incorporated and has issued stock shares) like it could with a 401(k) plan.

Eligibility Requirements of a SEP IRA

Any business owner can open and contribute to a SEP IRA since they’re easy to open, fund, maintain, and invest with. However, they’re mostly used by small business owners with no employees, or just a few employees, because of the SEP IRA rule that requires that if you contribute for yourself, you must also contribute an equal percentage of compensation for all eligible participants.

The IRS allows business owners to set minimum requirements that employees must meet to be eligible to receive employer contributions in a given year. These requirements can be less restrictive than the IRS’ rules for all SEP IRA plans, but not more restrictive. The IRS minimum employee eligibility requirements for SEP IRA participants are as follows:

  • The employee must be 21 years of age or older.
  • The employee must have worked for the employer for at least three of the last five years.
  • The employee must have received at least $750 in compensation in tax year 2023 or 2024.

SEP IRA Rules

Any business of any size or structure (LLC, partnership, S-corp, C-corp, or sole proprietor) can establish, fund, and maintain a SEP IRA plan.  Self-employed individuals, including independent contractors and freelance workers with no employees, can set up and fund a SEP IRA.  In order to fund a SEP IRA, however, you need to earn income from some sort of work performed to make a contribution for yourself.  

If you are a business owner with employees, you may make SEP IRA contributions to your employees’ accounts and your own, whether or not the business is profitable.  However, the business must earn a profit in order to take a tax deduction on the contributions.  Here are the other rules you must follow if you plan to open and contribute to the plan.

Income Limits

Having a very high income can limit the amount that can be contributed when participating in a retirement plan. For instance, the maximum eligible income limit for making a contribution to a SEP IRA in 2024 is $345,000. 

Your contributions are based on this income limit because SEP IRA contributions, for both employee participants and self-employed SEP IRA owners, are limited to no more than 25% of compensation.  

Contribution Limits

Because they are an employer-based retirement plan, SEP IRA contribution limits are much higher than those of a traditional IRA. For 2024, the maximum contribution limit is $69,000. However, your contribution can’t be more than 25% of your total compensation for the year.  

For business owners, your compensation is your net earnings minus the contributions to your own SEP-IRA and then minus half of your self-employment tax.  Therefore, a self-employed individual can make a SEP IRA contribution based on as much as $345,000 in income, but the contribution can be no greater than $69,000 for the 2024 tax year.

When contributing to an employee’s SEP IRA, you can’t exceed 25% of the employee’s compensation. There’s no catch-up contribution with a SEP IRA for those 50 and older. You must contribute to your account by the tax filing deadline (including extensions) for the year, which is usually April 15.  

IRS rules state that if you obtain an extension for filing your tax return, you have until the end of that extension period (October 15th) to deposit a contribution, regardless of when you actually file your (or your business’) return.

Withdrawal Rules

Since they are fully invested immediately, your contributions and any earnings on your invested contributions are held in your account and can be withdrawn whenever you want. However, if you withdraw the money before reaching the age of 59 ½, you’ll have to pay a 10% tax penalty.

Withdrawals after the age of 59 ½ are not subject to the early withdrawal penalty, but they are still taxable in the year you receive the withdrawal.

Distributions and Rollovers

Just like Traditional IRAs, you must begin withdrawing required minimum distributions (RMDs) from your SEP IRA once you reach the age of 73. Section 107 of SECURE Act 2.0 increases the RMD age to 75 for people who: A) attain age 74 after December 31, 2032, or B) attain age 75 after January 1, 2033.

SEP IRA contributions and earnings can also be rolled over tax-free to other similar IRAs, such as Roth IRA, traditional IRA, and 403(b) plan. The Internal Revenue Service (IRS) offers a rollover chart to determine what type of retirement plans you can roll over to and, depending on the receiving account’s type, whether the rollover action will be a taxable event for you.

How To Open a SEP IRA Account

You can open a SEP IRA at a bank, brokerage, insurance, or another qualified financial institution. However, most business owners prefer brokers over banks since they offer a larger variety of investment options. Compare brokers and custodians, and review investment options, fees, and minimum investments before you choose one.

Here’s how you can open your SEP IRA:

  • Fill out IRS Form 5305-SEP to create a formal written agreement.
  • Give each eligible employee a copy of the form and provide them with information about the retirement plan.
  • Set up separate IRAs for all eligible employees with your account provider.

How To Invest in a SEP IRA Account

Once your account is set up, you can choose your investments based on what your account custodian offers you access to buy and sell. Usually, banks offer limited choices, such as certificates of deposit. However, a broker or investment firm can usually provide you access to mutual funds, stocks, bonds, and more.

Your investments should be based on your risk tolerance, your current age, and your projected retirement age. If you have a higher risk tolerance and you’re still years away from retirement, you may want to consider investing in index funds, which hold a diverse mix of stocks and carry low annual expense ratios. The closer you are to retirement, the more you’d want to allocate towards bond funds and bonds.

It is always a very good idea to consult a licensed, experienced financial advisor or Certified Financial Planner™ (CFP) practitioner for individualized investment advice based on your particular financial resources and goals.

SEP IRA vs. Other Retirement Plans

A SEP IRA is a better option for self-employed individuals with a higher income because it offers a higher contribution limit than a personal IRA or Roth IRA. A 401(k) is usually a better choice for businesses with a lot of employees. 

If you have a lot of employees, a SEP IRA can be very expensive for you as a business owner who wants to maximize your own retirement account contributions since you’re required to make equal contributions for all eligible employees.

The Traditional SEP IRA and Traditional IRA both involve pre-tax contributions. This means that you’ll receive tax benefits upfront, but your retirement withdrawals will be taxed as ordinary income in the year in which you take them. With a Roth SEP IRA and Roth IRA, your contributions are with after-tax dollars, but you’ll typically receive tax-free distributions in retirement, pending certain qualifiers being met.

The main benefit of SEP IRAs over Traditional and Roth IRAs is the higher contribution limit. SEP IRAs also allow employer contributions, while Roth and Traditional IRAs don’t.

Open a SEP IRA and Start Investing Today

If you’re self-employed, a SEP IRA is a good option for a tax-advantaged retirement plan. With a high contribution limit, it allows you to save a large amount each year. Your savings continue to grow tax-deferred until you retire and/or begin taking money out.

A SEP IRA is a good choice if you have no or only a few employees and don’t plan to hire more employees in the future.