How Do Simplified Employee Pension (SEP) IRAs Work?

ByAngelique Cruz
Edited byScott Strandberg

Updated: June 27, 2023

ByAngelique Cruz
Edited byScott Strandberg

Updated: June 27, 2023

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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.

Fast Facts on SEP IRA

 

Beyond simply knowing the definition of a SEP IRA, it's best to understand how it works and varies from other retirement account options.

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Small business owners or self-employed individuals can use a SEP IRA to contribute to their employees' retirement fund or their own.

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SEP IRAs are ideal for freelancers and small business owners because contributions are discretionary — you don't have to do it annually.

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SEP IRAs share similarities with traditional IRAs — contributions and earnings for both are untaxed, while income tax applies to withdrawals.

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Unlike other retirement accounts, only employers can contribute to SEP IRAs. However, all contributions and earnings belong entirely to the employee.

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Employers can contribute up to $66,000 (for 2023) to a SEP IRA or up to 25% of the employee's gross annual income (whichever is less).


Understanding SEP IRAs

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.

Comparing Traditional and SEP IRAs

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).

IRA Component
SEP IRA
Traditional IRA

Tax Treatment

Tax-deferred growth

Tax-deferred growth

Target Demographic

Self-employed individuals and small
business owners

Anyone with earned income

Contribution Limits

Maximum of $66,000 per year
(2023)

Maximum of $6,500 per year (2023)

 

No catch-up contributions*

Additional $1,000 (total of $7,500)
if 50 or older

Required Contributions

Discretionary; not required every year

Discretionary; not required every year

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.

Creating a SEP IRA

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.

1
Choose a Financial Institution to Serve as Trustee

The IRS mandates that all IRAs have a custodian. While banks are often an obvious choice, the IRS has a list of approved non-bank custodians you can use for SEP IRAs. Remember, your custodian keeps and manages your account, so comparing costs and investment options between several can help you find one that works best for you.

2
Execute a Written Agreement

Create a document that details the employer's name, the eligibility requirements for employee participation, an allocation formula and an official's signature. You can use the IRA's Form 5305-SEP, except if the following scenarios apply:

  • You maintain any other qualified non-SEP plan
  • You have leased employees
  • You don't want to follow the calendar year
  • You want to factor Social Security contributions into your allocation formula

You can use a prototype document instead, which most qualified financial institutions provide.

3
Provide Information to Participants

Your employees must know what a SEP IRA is, along with its contribution limits and tax treatment. They should also understand what happens if and when they make withdrawals.

Whether you use Form 5303-SEP or a prototype document, provide your employees with the following information:

  • The SEP IRA may earn differently than other IRAs (if they have one).
  • They will receive documentation of any changes in the plan and its effects within 30 days of the effective date.
  • You will provide them a document detailing any contributions made to their SEP IRA by January 1 of the following year (or the beginning of your fiscal year if using a prototype document).

All employees must receive a copy of the form and its instructions.

4
Set up a SEP IRA Account for Each Employee

You must set up a SEP IRA for all eligible employees with banks, insurance companies or other qualified financial institutions. However, it's crucial to understand that employees are fully responsible for any necessary investment decisions for their accounts.

When you make your first contribution, each participating employee receives a statement from the financial institution. After this, notices regarding contributions arrive at least annually. The institution must also explain any fees or commissions they apply to withdrawals from the SEP IRA.

SEP IRA Eligibility

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.


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Must have worked for at least 3 years

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Must have been compensated at least $750 (in 2023) to be eligible

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Must be at least 21 years old


SEP IRA Contribution Rules and Limitations

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.

Contribution Summary
2023

Maximum Contribution

$66,000 or 25% of annual compensation

Minimum Compensation

$750

Maximum Compensation

$330,000

SEP IRA vs. 401(k) Employer-Matching

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.

Calculation
SEP IRA
401(k) Employer-Matching

Net Income

$100,000

$100,000

Contribution Rate

25%

4%

Employee Contribution

N/A

$100,000 * 4% = $4,000

Employer Contribution

N/A (Already factored in)

$4,000 (100% match)

Total Contribution

25% of $100,000 = $25,000

$4,000 (employee) + $4,000 (employer) = $8,000

SEP IRA Withdrawal Rules and Penalties

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.

Age
Withdrawal Cost

Under 59.5 years old

If you withdraw funds from your SEP IRA plan before you turn 59.5, the withdrawn amount becomes taxable — that year's income tax rates apply. And on top of that, you also pay a 10% penalty.

59.5 years old and above

Once you're 59.5, you can withdraw from your SEP IRA without incurring the 10% penalty. However, the current year's tax rates still apply.

SEP IRA FAQ

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.

Can I participate in other IRAs if I have a SEP IRA?
Is there a deadline to set up a SEP IRA?
Who can establish a SEP?
Can each of my employees choose a different financial institution for his (or her) SEP-IRA?
Can I establish SEP IRAs for all my employees?

Expert Insights on SEP IRA

MoneyGeek reached out to finance professionals — especially those with extensive experience in wealth management and retirement readiness — and gathered their insights about SEP IRAs. Their responses on maximizing your retirement account and investment options may provide you with additional information.

  1. Why do you think the IRS set the withdrawal age for SEP IRAs at 59.5?
  2. What options are available for investing the funds within a SEP IRA, and what factors should individuals consider when choosing investment strategies?
  3. How can individuals maximize a SEP IRA?
Cicely Jones
Cicely JonesFinancial Planner, Certified Retirement Education Specialist
Taylor Jessee
Taylor JesseeCPA, CFP® and founder of Impact Financial

Related Resources

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.

About Angelique Cruz


Angelique Cruz headshot

Angelique Cruz has been researching personal finance for three years, with expertise in macroeconomics, financial statistics and behavioral finance. After a decade-long stint as a management consultant creating professional and personal development programs, she now specializes in writing informative content around personal, auto and home loans. Angelique has a degree in psychology from the Ateneo de Manila University.


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