What Is a SEP IRA and Who Is Eligible?

If you’re self-employed, contributing to a SEP IRA may be a great way to fund your retirement.

In this article, I’ll explain how SEP IRAs work (hint: they’re similar to traditional IRAs) and lay out the SEP IRA contribution limits for 2021.

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What Is a SEP IRA?

A SEP IRA is a tax-advantaged retirement plan. The acronym stands for Simplified Employee Pension Individual Retirement Account.

Any employer can establish a SEP plan, but it’s more typical for someone who’s self-employed or runs a very small business.

SEP IRAs are lower maintenance and less expensive for companies than traditional 401(k) plans. They also offer much higher contribution limits than other IRAs.

If you operate a sole proprietorship, a partnership, a single-member LLC, an S Corporation or a C Corporation, you can establish a SEP IRA. If you contribute to a 401(k) as an employee, you can also set up a SEP IRA for your side hustle.

“The SEP is great for the self-employed. It requires almost no paperwork to get started and is incredibly flexible,” money expert Clark Howard says. “It is the easiest way for someone who has a side gig or works for themselves full-time to reduce current tax and to save big toward retirement.”

How Does a SEP IRA Work?

SEP IRAs are strikingly similar to traditional IRAs. You'll need a custodian. Clark recommends Fidelity, Schwab and Vanguard.

Your investment options within a SEP IRA depend on who you choose as your account’s custodian. Otherwise, they’re the same as traditional IRAs at the same investment company.

Employees can't contribute to a SEP IRA. Only the employer can contribute. Those contributions are pre-tax dollars — the same as they would be for a traditional 401(k). In other words, they're tax-deductible for the business.

Once they retire, employees are taxed on withdrawals as ordinary income, just as if they took money out of a traditional 401(k) or IRA.

SEP IRAs don't require much in the way of paperwork, although you do have to fill out Form 5305-SEP to establish one. They're also flexible. Employers can skip contributions in years when the business isn't doing well.

If you're a business owner and you have qualifying employees, SEP IRAs can get expensive fast. You have to contribute the same percentage for each employee, because contributions are essentially profit-sharing. So if you give yourself 15% of your annual compensation, you also have to contribute 15% to every qualified employee's account.

If you have employees and you decide that a SEP IRA is prohibitive, you have two choices:

  1. Upgrade to a full-fledged 401(k). You'll need to conduct annual non-discrimination tests, and a full-fledged 401(k) will significantly increase your administrative burden. You may even need to hire a compliance person to oversee the retirement plan.
  2. Switch to a SIMPLE IRA. You (and your employees) may be disappointed by the contribution limits. But a SIMPLE IRA is a good solution if you own a small business, aren't ready to support a traditional 401(k) plan but want to offer retirement benefits.

Many people use a SEP IRA as a last resort to reduce their taxable income. That’s because if you’re self-employed, you can reduce the prior year’s taxable income on contributions you make through tax day (beyond Dec. 31) as long as you’ve yet to file your return.

SEP IRA Contribution Limits for 2021

Company TypeContribution Limit
Sole proprietor, partnership or LLCUp to 20% of your net earned income or $58,000, whichever is less*
S-corp or C-corpUp to 25% of your W-2 wages or $58,000, whichever is less^

#tablepress-414 from cache

*This requires a calculation, which you can outsource to a tax specialist. If you want to do it on your own, you'll need to use the rate table worksheet in Chapter 6 of IRS Publication 560. You can also make the calculation via another IRS document called "Calculating Your Own Retirement Plan Contribution."

^You can use a maximum of $290,000 in compensation for these purposes. Anything you make beyond $290,000 isn’t eligible for additional employer contributions.

Employees can’t contribute to SEP IRAs.

The company must establish a contribution percentage for all eligible employees, from the owner to the worker making the least amount of income.

Here’s what defines someone as a “qualified” employee for SEP IRA purposes:

  • At least 21 years old
  • Earned three years of service within a five-year period ($600+ in income during a calendar year is enough to earn a year of service)

Those are the legal requirements, but companies can choose to set less restrictive rules on who qualifies as an employee.

SEP IRA Withdrawal Rules

If you're familiar with the rules for traditional IRAs (or even traditional 401(k) plans), you'll probably recognize the SEP IRA withdrawal rules.

You’re allowed to cash out some or all of your SEP IRA without penalty once you reach 59½ years old. If you withdraw before then, you’ll pay a 10% early withdrawal penalty to the IRS.

There are exceptions that allow someone to withdraw penalty-free prior to 59½:

  • SEPP program (No, that extra "P" is not a typo; this is something completely different.)
  • Disability or death
  • Post-secondary education
  • First-time home buyer (up to $10,000)
  • IRS tax levy
  • Health insurance premiums (after 12+ weeks of unemployment)
  • Military reservists called into active duty for 180+ days

IRS rules also state that you must start taking money out of your SEP IRA shortly after your 72nd birthday (by April 1 the following year, to be precise). These annual withdrawals are called Required Minimum Distributions (RMDs).

Advantages of a SEP IRA

Here are some of the positive attributes of SEP IRAs:

  • High contribution limits. Compared to a traditional or Roth IRA, you can put away more than three times as much money each year.
  • Less administrative work. SEP IRAs are easier — or dare I say "simpler" — than 401(k) plans.
  • Flexible contributions. Even if you have employees, you aren't on the hook every year. It's up to you to decide whether you'll hand out distributions. Also, you and any employees you have are still allowed to contribute to an IRA.
  • Immediate 100% vesting. No one has to wait to secure employer contributions.
  • Allows for employees. If you're self-employed and you create a solo 401(k) plan, you have to change as soon as you hire a qualifying employee.
  • Great for reducing your business tax bill. All your contributions as an employer are tax-deductible.

Disadvantages of a SEP IRA

Here are some of the negative attributes of SEP IRAs:

  • Expensive if you have employees. If you're contributing a healthy percentage to yourself as the business owner, you'll have to give an equal percentage to every other employee. That can get expensive fast.
  • Employees can't make contributions. SEP IRAs don't allow employee contributions at all.
  • No catch-up contributions. You (or your employees) can't contribute an extra $6,500 if you're 50 or older.
  • No Roth option. Employer contributions have to be pre-tax. So there isn't an option to contribute to a Roth via a SEP IRA.
  • Flexible contributions. If you're an employee, this can be a disadvantage because your company can just decide "no contributions this year."

SEP IRA vs. Solo 401(k)

SEP IRAs and solo 401(k) plans often get compared because they’re both available to you if you report self-employment income.

Take a look at this chart that illustrates some of their similarities and differences:

AttributeSEP IRA, Solo 401(k) or Both
Employer contributionsBoth
Employee contributionsSolo 401(k)
Catch-up contributionsSolo 401(k)
Roth optionSolo 401(k)
Loan optionSolo 401(k)
Allowed to have employeesSEP IRA
Less administrative workSEP IRA
Flexible contributionsSEP IRA

#tablepress-413 from cache

As you can probably tell, solo 401(k) plans can offer more features, but SEP IRAs are more streamlined.

Final Thoughts

You may have heard of the 80/20 rule, also known as the Pareto Principle. If you haven’t, the gist is that in most cases, you can achieve 80% of the results with 20% of the effort.

That fits a SEP IRA to a tee, especially compared to a solo 401(k). It doesn’t have as many bells and whistles, but it sure is easier to set up and manage. Plus, you get most of the same benefits.

A SEP IRA can be an excellent tool to sock away retirement money. But if you’re eligible to contribute to a Roth IRA and you’re planning to set aside $6,000 or less, just do that; you don’t need to go through the trouble of setting up a SEP IRA.

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