What Is a Simplified Employee Pension (SEP)?
A simplified employee pension (SEP) is an individual retirement account (IRA) that an employer or a self-employed person can establish. The employer is allowed a tax deduction for contributions made to a SEP IRA and makes contributions to each eligible employee’s plan on a discretionary basis.
Additionally, under the Setting Every Community Up for Retirement Enhancement (SECURE) Act, enacted on Dec. 20, 2019, small employers get a tax credit to offset the costs of starting a 401(k) plan or SIMPLE IRA with auto-enrollment. That’s on top of the start-up credit they already receive.
SEP IRAs often have higher annual contribution limits than standard IRAs. In a sense, they're a cross between a traditional IRA and a 401(k)—like the latter, they can receive employer contributions—those employer contributions are vested immediately.
- A simplified employee pension (SEP) is an individual retirement account (IRA) that an employer or self-employed individual can establish.
- Small businesses and self-employed individuals can use SEP IRAs to meet retirement savings needs.
- SEP IRA contribution limits are annual and often higher than standard IRAs and 401(k)s.
SEP Account: Jessica Perez
How a Simplified Employee Pension (SEP) 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 IRA to contribute to their own retirement at higher levels than a traditional IRA allows.
Small organizations favor SEP IRAs because of eligibility requirements for contributors, including a minimum age of 21, at least three years of employment, and a $650 compensation minimum for 2022 ($750 for 2023). In addition, a SEP IRA allows employers to skip contributions during years when business is down.
SEP IRAs 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 requirement—decisions about whether to contribute and how much can change each year.
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.
Contributions to SEP IRAs are immediately 100% vested, and the IRA owner directs the investments. An eligible employee (including the business owner) who participates in their employer’s SEP plan must establish a traditional individual retirement plan (IRA) to which the employer will deposit SEP contributions.
Some financial institutions require the traditional IRA to be labeled as a SEP IRA before they will allow the account to receive SEP contributions. Others might allow SEP contributions to be deposited to a traditional IRA regardless of whether the IRA is labeled as a SEP IRA.
Contributions to a SEP IRA are immediately 100% vested, and account owners must choose their investments themselves from a list provided by the account trustee.
SEP IRA Contribution Limits
Contributions made by employers cannot exceed the lesser of 25% of an employee’s compensation, or $66,000 in 2023 (up from $61,000 in 2022). As with a traditional IRA, withdrawals from SEP IRAs in retirement are taxed as ordinary income.
When a business is a sole proprietorship, the employee-owner pays themselves wages and may also make an SEP contribution, which is limited to 25% of wages (or profits) minus the SEP contribution. For a particular contribution rate (CR), the reduced rate is CR ÷ (1 + CR) for a 25% contribution rate. This yields a 20% reduced rate, as in the above example.
Because the funding vehicle for a SEP plan is a traditional IRA, SEP contributions, once deposited, become traditional IRA assets and are subject to many of the traditional IRA rules, including the following:
- Distribution rules
- Investment rules
- Contribution and deduction rules for traditional IRA contributions as they apply to an employee’s regular IRA contributions, not the SEP employer contributions
- Documentation requirements for establishing an IRA
In addition to the documents required for establishing an SEP plan (discussed later), each SEP IRA must meet the documentation requirements for a traditional IRA.
SEP IRA Rules
SEP IRAs were primarily designed to encourage retirement benefits among businesses that would otherwise not set up employer-sponsored plans. Not all businesses can establish them, though. Only sole proprietors, partnerships, and corporations are eligible.
As for participants, too high an income can be a limitation—the 2023 eligible compensation limit is $330,000 in 2023. Unlike qualified retirement plans, the SEP does not allow participants, including the business owner, to borrow up to the lesser of 50% or $50,000 of their vested balance, however.
Specific employees may be excluded by their employer from participating in a SEP IRA, even if they would otherwise be eligible based on the plan’s rules. For example, workers covered in a union collective bargaining agreement for retirement benefits can be excluded. Employees who are nonresidents can also be excluded as long as they do not receive U.S. wages or other service compensation from the employer.
Withdrawals and Contributions
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, generally, a 10% additional tax applies.
Rollover and Distributions
SEP contributions and earnings may be rolled over tax-free to other IRAs and retirement plans. Additionally, SEP contributions and earnings must eventually be distributed following the IRA-required minimum distributions rules.
SEP IRA vs. Individual 401(k)
A SEP IRA and an individual 401(k), also known as a solo 401(k), are both retirement accounts that allow employer contributions. However, they have two main differences.
The first is that although both accounts have the same maximum contribution limit, you can contribute the maximum to an individual 401(k) at a lower income level than a SEP IRA. In 2023, individuals making $150,000 or more can contribute up to the $66,000 maximum to a 401(k), whereas SEP IRA owners need to make $264,000 or more to contribute the same amount. Second, you can take a loan against the 401(k), which is not allowed with a SEP IRA.
If you are a small business owner with employees and a SEP IRA plan, you must contribute as much to their plans as yours.
A SEP IRA, however, is somewhat easier to set up and maintain. An individual 401(k) requires its owner to be more involved in its administrative responsibilities, and it can also generate higher fees than a SEP IRA.
SEP IRA vs. Traditional IRA vs. Roth IRA
There are important differences between these three retirement accounts. With a traditional IRA, you contribute tax-free money, reducing your tax bill in the year you make the contribution. However, when you withdraw funds in retirement, they are taxed as ordinary income, and you are required to make distributions once you reach the age of 73 (up from 72 and 70½ in previous years). This makes it best for people who expect to be in a lower tax bracket when they retire.
A Roth IRA reverses the process. You have already paid income tax on the money you contribute, so withdrawals in retirement are tax-free. This makes a Roth IRA better for people who expect to be in a higher tax bracket in retirement. In addition, there are no required minimum distributions from a Roth IRA, so if you don’t need the money, you can just let it sit there and pass the account on to your heirs.
A SEP IRA is available to any employer, including self-employed persons. It allows employer contributions, which traditional and Roth IRAs do not, and all contributions to it are tax-free, meaning that distributions in retirement will be taxed as ordinary income. The maximum contribution limit for a SEP IRA is considerably higher than that for either a traditional or Roth IRA. Employers can get a tax deduction for their contribution, which means when the self-employed person is both employer and employee, they can get that tax deduction. SEP IRAs were invented as a way to help small businesses provide employer-sponsored retirement plans to their employees and owners.
How Does a SEP IRA Work?
A SEP IRA allows small business owners to set up contributions to their own accounts and those of their employees.
What Is the Benefit of a SEP IRA?
SEP IRAs allow the holders to reduce taxable income and take advantage of compounding interest on tax-deferred contributions. SEP IRAs also have higher contribution limits than other IRAs.
What Is the Difference Between a SEP IRA and a Traditional IRA?
The most significant difference is the contribution limit, where a traditional IRA allows for a $6,500 total annual amount (with a $7,500 catchup contribution for those over 50). You can contribute up to $66,000 in 2023.
The Bottom Line
A SEP IRA is a retirement plan option for small business owners and qualified employees. It has higher contribution and income limits. To set one up, small business owners must choose a plan provider and make contributions. If they have employees, they are required to contribute to their plans equally.