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How Does a Simplified Employee Pension (SEP) IRA Work?

Retirement savings accounts known as SEP IRAs have distinct advantages

A simplified employee pension (SEP) IRA is a retirement savings plan established by employers for the benefit of their employees and themselves. It can also be established by self-employed individuals. Employers may make tax-deductible contributions on behalf of eligible employees to their SEP IRAs.

SEPs are advantageous because they are easy to set up, have low administrative costs, and allow an employer to determine how much to contribute each year.

SEP IRAs also have higher annual contribution limits than standard IRAs. Fundamentally, a SEP IRA can be considered a traditional IRA with the ability to receive employer contributions. One major benefit of a SEP IRA is that employer's contributions are vested immediately.

Key Takeaways

  • A SEP IRA is an employer-sponsored retirement plan that can be set up by sole proprietors, partnerships, and corporations.
  • You must have earned at least $650 from an employer to qualify for a SEP.
  • SEP IRA annual contribution limits are significantly higher than those for traditional IRAs.
  • Employers, not employees, make contributions to SEP IRAs, and the decision about whether and how much to contribute each year can vary.
  • Employees manage the investment decisions of their SEP IRAs within the limits set up by the plan’s trustee.
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SEP Account: Jessica Perez

Who Can Participate in a SEP IRA Plan?

According to IRS rules as of 2021, an individual must be at least 21 years old, have worked for the employer in at least three of the previous five years, and have received a minimum of $650 in compensation from the employer during the current year to qualify for an employee SEP IRA.

Individual employers are allowed to be less restrictive in their qualification requirements for their specific SEP IRA plans but may not be more restrictive than IRS rules.

Employers may exclude certain types of employees from participating in a SEP IRA, even if they would otherwise be eligible based on the plan’s rules. Workers who are covered in a union agreement that bargains for retirement benefits can be excluded, as can workers who are immigrants without papers as long as they do not receive U.S. wages or other service compensation from the employer.

SEP IRAs were primarily designed to encourage retirement benefits among businesses that would otherwise not set up employer-sponsored plans. Sole proprietors, partnerships, and corporations can establish SEPs.

SEP IRAs are tax-deferred accounts and have the same investment options as traditional IRAs.

How a SEP IRA Works

A SEP IRA is an attractive option for many business owners because it does not come with many of the start-up and operating costs of most conventional employer-sponsored retirement plans. Many employers also set up a SEP plan so that they can contribute to their own retirement at higher levels than a traditional IRA allows. And workers can start a SEP for their self-employed business even if they participate in an employer's retirement plan at a second job.

SEP IRA accounts are treated like traditional IRAs for tax purposes and allow the same investment options. The same transfer and rollover rules that apply to traditional IRAs also apply to SEP IRAs. When an employer makes contributions to SEP IRA accounts, it receives a tax deduction for the amount contributed. Additionally, the business is not locked into an annual contribution—decisions about whether to contribute and how much can change each year.

Another thing that is good for business owners is that the employer is not responsible for making investment decisions. Instead, the IRA trustee determines eligible investments, and the individual employee account owners make specific investment decisions. The trustee also deposits contributions, sends annual statements, and files all required documents with the IRS.

SEP IRA Contributions

One big advantage of a SEP IRA is the amount that can be contributed annually. As of 2021, contributions cannot exceed the lesser of 25% of the employee’s compensation for the year or $58,000 and $61,000 for 2022. The limit on compensation that can be used to calculate the contribution is $290,000 in 2021 and increases to $305,000 in 2022.)

This contribution limit is significantly higher than the $6,000 limit imposed on standard IRAs, which doesn't include the extra $1,000 that anyone aged 50 or over is permitted as a catch-up contribution. The deadline for contributions is the tax filing deadline (plus extensions) of the company or self-employed individual who sets up the SEP IRA.

Article Sources

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  1. Internal Revenue Service. "SEP Plan FAQs." Accessed Dec. 4, 2021.

  2. Internal Revenue Service. "Simplified Employee Pension Plan (SEP)." Accessed Dec. 4, 2021.

  3. Internal Revenue Service. "2022 Limitations Adjusted As Provided in Section 415(d), etc.," Page 1. Accessed Dec. 4, 2021.

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