How Do Simplified Employee Pension (SEP) IRAs Work?

A Simplified Employee Pension Plan (SEP) is a retirement plan that's easy to set up and maintain and doesn't require you to fulfill any IRS filing requirements. It's typically a good option for self-employed individuals, freelancers and business owners (whether or not you have employees) because contributions are tax-deferred and tax-deductible and can vary annually.

It works similarly to a traditional IRA but with higher contribution limits. However, not everyone can contribute to a SEP IRA — only employers can.

It's never too early to begin saving for retirement, and opening a SEP IRA is an excellent option to ensure you'll have financial flexibility in your golden years.

A SEP IRA is a retirement plan option that may be best suited for individuals with fluctuating incomes, such as freelancers or small business owners. However, there's more to understanding a SEP IRA beyond its definition.

A SEP IRA is a tax-advantaged account, so your funds earn tax-deferred, and contributions are tax-deductible. It also has higher contribution limits than some other retirement accounts. Employers aren't obligated to contribute yearly — or, if they do, it doesn't need to be the same amount annually. However, contribution amounts must be the same for each employee.

Among other retirement plans, a SEP IRA most closely resembles a traditional IRA. You contribute using pre-tax dollars for both, allowing your funds to grow tax-deferred. Contributions are discretionary for both, so you don't have to add money to your plan annually. Required minimum distributions for both begin when you turn 72.

However, there are also significant differences between them, especially regarding contributions. For example, employers don't need to contribute to traditional IRAs but must do so for SEP IRAs. Limits for SEP IRAs are also considerably higher. While the IRS caps contributions for traditional IRAs at $6,500 ($7,500 for those 55 and older), 2023 limits for SEP IRAs can be up to $66,000 or 25% of an employee's gross income (whichever is less).

A catch-up contribution is an amount you can contribute on top of that year's limits if you're 50 or older. Technically, SEP IRAs don't allow catch-ups because only employers can contribute.

However, you can set up your SEP IRA to permit non-SEP contributions. This way, you can make regular IRA contributions, including a catch-up contribution if eligible. However, that means your contributions to other IRAs must decrease.

Now that you know the definition of a SEP IRA and how its contributions work, the next logical step is understanding the process of establishing one. MoneyGeek provides you with the essential steps.

If you're setting up a SEP IRA account for your employees, you must ensure they're qualified. MoneyGeek highlights the eligibility requirements below. Note that these apply to employees and business owners alike.

As with any retirement plan, a SEP IRA has specific rules and limits for contributions. With no IRS filing necessary, it's a convenient way for freelancers, small business owners and self-employed individuals to set aside money for retirement. Your funds have tax-deferred earnings, and contributions are tax-deductible.

Only employers can make contributions, and they’re discretionary. Although you don't have to contribute every year, every qualified employee's SEP IRA must receive the same amount when you do. Typically, SEP IRAs do not accept catch-up contributions unless you set it up to allow non-SEP contributions. However, doing so decreases your tax-deductible amount.

Another angle worth exploring is how SEP IRAs differ from 401(k)s. Although both are employer-sponsored retirement accounts, each works differently. A direct comparison might be the best way to determine which is ideal for you and your financial goals.

Let's use an example of a self-employed individual earning a net income of $100,000. For this scenario, we'll assume a 25% contribution rate for the SEP IRA. For the 401(k), we'll use a 4% contribution rate but will also include a 100% matching contribution from the employer.

The table below details the computation and its resulting figures. Remember, these are only examples — you may get different results if you apply them to your situation.

A SEP IRA helps you set up a nest egg for your retirement. However, your withdrawals might be subject to penalties and taxes, depending on when you make them.

Although only employers can contribute, the account's contents are 100% vested. You cannot stop employees from withdrawing from their SEP IRAs, but if they do it before they're 59.5 years old, they'll incur a 10% penalty on top of the required income tax.

Withdrawals made after an employee turns 59.5 are still taxed but no longer penalized. That includes required minimum distributions, which begin when the accountholder turns 72.

MoneyGeek included the answers to some commonly asked questions about the SEP IRA. These may provide additional details and complement the information about what a SEP IRA is and how it works.

Many factors affect our retirement readiness level. Besides understanding various retirement plan options, you should consider spending habits, income streams and money management strategies. The following pages provide you with more information.

• Older Adults’ Guide to Income Streams and Money Management in Retirement: One challenge that comes with retirement is the limited source of income. MoneyGeek provides tips on how to create and manage income streams in your golden years.
• Smart Spending in Retirement: Money management has never been more important than when you’re retired. Now that your income is fixed, it’s time to have a solid budget and make wise spending choices.
• Average Retirement Account Balance of Americans: How much does the average American have in their retirement accounts? MoneyGeek presents the numbers.
• How to Retire During a Period of High Inflation: Retirement is never easy — especially when inflation is high. That said, MoneyGeek shares some strategies that still make it possible.
• Roth IRA: A SEP IRA isn’t the only financial product that can help you save for retirement. Check out what a Roth IRA is and whether or not it can work for you.