Payments made to a Simplified Employee Pension (SEP) IRA are tax deductible for employers, but there is a maximum limit on how much may be contributed and deducted annually.

A business can make tax-free contributions to an individual retirement account for each of its employees. SEPs are funded solely by the employer using tax-deductible dollars. As of 2019, employers could contribute as much as 25% of an employee's compensation as long as the contributions did not exceed $56,000. This goes up to $57,000 in 2020.

Key Takeaways

  • Employers can deduct payments to a Simplified Employee Pension (SEP) IRA for an employee but only to certain limits.
  • Business owners who start up a SEP IRA may be eligible for a tax credit of up to $500 per year.
  • SEP contributions and earnings are held in SEP-IRAs and can be withdrawn at any time, subject to the general limitations imposed on traditional IRAs.

A SEP IRA is a type of traditional IRA available to self-employed individuals, freelancers, and small-business owners. Employees are not able to contribute to a SEP IRA that the company they work for opens for them.

Employer contributions for each eligible employee must be based only on the first $280,000 of compensation for 2019 and be the same percentage of compensation for every employee. Employers do not have to contribute every year. However, when contributing to these plans, employers must contribute to the SEP-IRAs of all participants who actually performed personal services during the year for which the contributions are made. This is the case even for employees who die or terminate employment before the contributions are made.

Additionally, business owners who start up an SEP IRA may be eligible for a tax credit of up to $500 per year for the first three years that the SEP IRA account is open.

Employers can contribute as much as 25% of an employee's gross annual salary and the self-employed 20% of their net adjusted annual self-employment income.

What Is the Eligibility for an Employer’s SEP IRA?

As of 2019, employers can set up a SEP IRA. Once such a plan exists, all employees must be included if they are:

  • 21 or older;
  • Have worked for the employer for at least three of the previous five years; and
  • Have been paid at least $600 in earned income from your business for the year.

An employer could set lower age or shorter time requirements to qualify than listed above, but they must at least meet the standards above. The IRS provides the following example (dates have been modified):

"Employer X maintains a calendar year SEP. The eligibility requirements under the SEP are: an employee must perform service in at least three of the immediately preceding five years, reach age 21 and earn the minimum amount of compensation during the current year. Bob worked for Employer X during his summer breaks from school in 2016, 2017 and 2018, but never more than 34 days in any year. In July 2019, Bob turned 21. In August 2019, Bob began working for Employer X on a full-time basis, earning $30,000 in 2019. Bob is an eligible employee in 2019 because he has met the minimum age requirement, has worked for Employer X in three of the five preceding years and has met the minimum compensation requirement for 2019."

For individuals who are not self-employed, as per IRS rules compensation used to determine SEP contributions includes the following:

  • Wages, tips, and other compensation from the employer subject to income tax withholding under section 3401(a),
  • Amounts described in Internal Revenue Code Section 6051(a)(8), including elective contributions made under a SIMPLE IRA plan, and
  • Compensation deferred under a 457 plan.

Compensation does not include amounts deferred under a Section 125 cafeteria plan.

Contribution Deadline and Withdrawals

The deadline for establishing a SEP IRA plan and making contributions is the filing deadline for the employer's tax return, including extensions. Catch-up contributions are not allowed in SEP IRAs as they are made by individuals rather than employers.

SEP contributions and earnings are held in SEP-IRAs and can be withdrawn at any time subject to the general limitations imposed on traditional IRAs. A withdrawal is taxable in the year received. If a participant makes a withdrawal before age 59½, a 10% additional tax generally applies. SEP contributions and earnings may be rolled over tax-free to other IRAs and retirement plans.