Your Easy Guide To The SEP IRA

Those who are self-employed and wanting to invest for retirement have several options, a simplified employee pension individual retirement account (SEP IRA) being one of them. This type of account allows self-employed people or employers to save for retirement. Their rules include higher contribution limits compared to other individual retirement accounts (IRAs) and blend the characteristics of an IRA and a 401(k).

Before opening an account, learn exactly that this type of individual retirement account entails and who it’s best suited for.

In Detail: What Is A SEP And Who Needs One?

A SEP IRA is a retirement account that works much like other IRAs, like a Traditional or Roth IRA, except that it's for business owners, self-employed individuals or freelancers. This type of account is meant to help business owners and their eligible employees have access to a retirement plan, where only the employer can make contributions.

The contributions are limited to what is enforced by the IRS. In most cases, contributions are eligible for a  tax deduction for employers. The contributions grow tax-deferred until distributions are taken. To participate in a SEP IRA, both employers and employees need to meet eligibility requirements.

How SEP IRAs Work

SEP IRAs work much like traditional IRAs, with a few notable exceptions.

Income Limits

Like other types of retirement plans, there is an income limit in which you’ll use to calculate the total amount of contributions you can make. This amount is $305,000 in 2022 and $330,000 in 2023. Whether you are contributing for your employees or as a self-employed individual, you can only use up to this maximum amount when calculating contributions you can make.

SEP IRA Contribution Limits And Rules

A SEP IRA has higher contribution limits compared to many other types of retirement accounts. It allows the employer to contribute up to 25% of the employee's total income, up to a maximum amount dictated by the IRS – up to $66,000 for 2023, up from $61,000 in 2022. That means if you want to contribute 25% of your income and that amount will exceed $66,000 this year, you can only contribute up to $66,000.

For those who are self-employed, you can only contribute up to 20% of your net income. This amount is your net profit, found in the IRS Schedule C — it takes your gross income and subtracts your qualifying business deductions and deductible portion of your self-employment tax.

Plus, the contribution amounts must be the same for employees and employers, up to the contribution limit. For example, if the employer wants to contribute 10% of your income into your SEP IRA account, you must do the same for your employees (assuming it’s under the contribution limit).

Employers can’t make catch-up contributions, even if you’re 50 and older. There is also no Roth version of the SEP IRA, so you will need to make pretax contributions and pay them when you take distributions. Any contributions you make for your employees are also typically eligible for deductions.

Vesting Rules

Vesting is when an employer gives their employees certain benefits over time. In the context of a retirement, it means the contributions you make to their employer-sponsored account. Some employers set up vesting schedules for certain retirement accounts to give employees full ownership over your contributions over a set period.

There is technically no vesting schedule for a SEP IRA. Meaning, any contributions you make to an employee’s account is 100% vested, or fully theirs.

Employee Exclusions

Participants will also need to be at least 21 years old and employees need to have worked for at least 3 of the past 5 years. Employees will also need to have earned a minimum of $750 in 2023 or $650 in 2022 to be eligible.

Although employees have control over their accounts, they can’t contribute themselves. However, they can make Traditional IRA contributions in their SEP IRA accounts. This amount is limited to $6,500 for the 2023 tax year. For those who are 50 and older, catch-up contributions of an additional $1,000 are allowed.

Contributions

Before contributing to a SEP IRA, you will first need to open one for yourself and any eligible employees. Do your research to find an account provider that is the best fit — a few features to compare include fees and investment options. You can make contributions by following the directions from the account provider on how to fund the account for yourself or your employees.

Rollovers

If your employees leave your company, they can choose to keep the account open (you won't contribute to it) or roll it over to a new or existing IRA. In general, most roll over their SEP IRA to a Traditional IRA since both utilize pretax contributions. If rolling it over to a Roth IRA, the account holder may be subject to taxes.

There are several ways to conduct rollovers, including:

• Direct rollover: The SEP IRA account provider will send a check directly to the account holder payable to the new financial institution, who will then deposit it into their new retirement account.
• Trustee to trustee transfer: The financial institution which holds the SEP IRA will work with the new financial institution to initiate the transfer.
• 60-day rollover: The SEP IRA account provider will send the account holder the funds directly, who will then have 60 days to deposit it into the new retirement account.

Distributions And Withdrawals

SEP IRAs are similar to Traditional IRAs in that you make tax-free contributions, but you’ll need to pay taxes when you take distributions. You can make withdrawals before age 59.5— but you’ll also take a 10% penalty in addition to taxes. There are early withdrawal exceptions such as a first-time home purchase.

SEP IRAs also have required minimum distribution (RMD). This amount may vary, but you must start to do it at 73 years old starting in 2023.

Pros And Cons Of SEP IRA Plans

Like all types of investment accounts, there are benefits and drawbacks, including:

Comparing SEP IRAs With Other Retirement Plans

While SEP IRAs offer plenty of benefits, this type of account may not be a good fit or available for everyone. Instead, you can consider the following option as you’re making your decision.

SEP IRA Vs. Roth IRA Vs. Traditional IRA

SEP, Traditional, and Roth IRAs offer similar features, such as the ability to save for retirement and tax benefits. While a SEP IRA and Traditional IRA allow you to contribute pre-tax dollars, a Roth IRA requires you to pay taxes on your contributions. However, you don’t pay taxes when you take distributions, but with SEP IRAs and Traditional IRAs, you would. 

Both Traditional and Roth IRAs allow catch-up contributions, whereas SEP IRAs don’t. It does have a much higher contribution limit — almost 10 times what you would get with a Traditional or Roth IRA.

Solo 401(k) Vs. SEP

Both a SEP IRA and a solo 401(k) are geared toward business owners who want to save for retirement.

Both offer higher contribution amounts compared to Traditional and Roth IRAs. However, SEP IRAs allow business owners to open accounts and make contributions for their employees, whereas a solo 401(k) is generally for solo business owners or freelancers. The latter type also allows account participants to make employee contributions in addition to an employer or profit-sharing contribution. The solo 401(k) allows catch-up contributions after age 50, unlike the SEP IRA.

How To Get A SEP IRA Account And Start Investing

Setting up a SEP IRA requires that you fill out the relevant IRS forms (your account provider can help with this step or send in IRS form 5305-SEP) and set up accounts for eligible employees. Once the accounts have been opened, you can then fund the accounts. Your employees can select the types of available investments to create their portfolio, and you can as well for your own account. Employees who wish to make Traditional IRA contributions can also do so once the account is open.

FAQs: Retirement Plans For The Self-Employed

What does SEP stand for?

SEP stands for Simplified Employee Pension (SEP) plans, most commonly known as a SEP IRA.

What is a SEP IRA vs. a 401(k)?

A SEP IRA and a 401(k) are both retirement plans geared toward solo business owners or freelancers. They both have high contribution limits. However, the SEP IRA doesn’t allow catch up contributions, and participants can’t make employee contributions unless it’s combined with a Traditional or Roth IRA.

Who qualifies for SEP IRAs?

Business owners who have 100 employees or less can qualify. As for employees, they have to be at least 21 years old and meet income requirements. Employees need to make a minimum of $750 in 2023 and $650 in 2022 to be eligible.

What are the disadvantages of a SEP IRA?

One of the main disadvantages of a SEP IRA is that you can’t make employee contributions. Plus, there are no catch-up contributions allowed, and employers need to make proportional contributions for every eligible employee if making contributions for themselves.

The Bottom Line: A SEP IRA Helps Small-Business Owners Save For Retirement

A SEP IRA offers business owners the opportunity to help themselves and their employees save for retirement. Opening an account allows you to take advantage of the many benefits, such as higher contribution limits and tax-deductible contributions.

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