A SEP IRA can be a simple and effective way for self-employed individuals and small business owners to save for retirement. However, it’s important to understand how it works and whether it’s right for you.
What is a SEP IRA?
SEP IRA stands for Simplified Employee Pension Individual Retirement Account. (Many people mistakenly think “SEP” stands for “Self-Employed”.) It’s a retirement plan that an employer or self-employed individuals can establish.
This account is primarily for self-employed individuals, small-business owners, entrepreneurs, and those who work as freelancers or on a contract basis.
Essentially, most entrepreneurs and business owners don’t have access to a traditional 401(k) with an employer match because they employ themselves. So, a SEP plan is an alternative to a 401(k) retirement plan. Additionally, if self-employed individuals have employees of their own, they can set up a SEP for their employees.
SEP IRAs have many benefits for entrepreneurs, which I’ll explain below.
How does a SEP IRA work?
A Simplified Employee Pension (SEP) IRA works similarly to a traditional IRAs. A business owner can set aside money for themselves in a SEP plan for retirement. According to the IRS, if a business owner has employees, they also must set aside an equal percentage of their employees’ pay into a SEP plan for their employees.
An important distinction is that SEP IRAs are funded by employer contributions; it is not money that comes directly from the employees’ salaries.
To put it another way, money is not withheld from employees’ salaries. The employer provides the SEP contribution in addition to their employee’s regular pay. The employee’s income is only used as a metric to determine how much to put into the SEP account.
So, if an employer wants to set aside 15% of their own salary for themselves, they must put 15% of their employees’ salaries into a SEP plan for them too. However, they do not withhold 15% of their employees’ salary; the SEP contribution is in addition to their income.
That’s why a SEP IRA is likely more beneficial to a solopreneur or someone with very few employees. Otherwise, it could be far too expensive for an employer to maintain.
SEP IRA Rules
One of the major benefits of a SEP IRA plan is that you can contribute up to 25% of your compensation into the account or up to $69,000 for 2024 – whichever is less. The same goes for your employees if you set up a SEP IRA for them too. You can only contribute up to 25% of their income or $69,000, whichever is less.
This is why so many people who are self-employed like using a SEP IRA. Plus, they have low operating costs and are not expensive to open. They are available to any size business, whether you are a one-person operation or have dozens of employees.
Advantages of a SEP IRA
One of the main advantages of a SEP IRA is its simplicity. Unlike other employer-sponsored retirement plans, such as a 401(k) or a profit-sharing plan, SEP IRAs are relatively easy to set up and maintain.
Employers simply need to fill out a one-page form and establish a SEP IRA account for each eligible employee. There are no annual reporting requirements, and employers are not required to contribute every year if they choose not to. This can be especially beneficial for self-employed individuals who may not have the time or resources to manage a more complex retirement plan.
Another advantage of a SEP IRA is its flexibility. Employers have the option to vary their contributions from year to year, depending on their business’s financial situation. This can provide a level of financial flexibility that may not be possible with other retirement plans, which often require a certain level of contributions each year.
Employers can also choose to contribute more in some years and less in others, depending on their needs and goals. This flexibility can be beneficial for both the employer and the employee, as it allows for retirement savings to be adjusted based on changing circumstances.
Disadvantages of a SEP IRA
One disadvantage of a SEP IRA is that contributions are limited by the IRS. For tax year 2024, the maximum contribution an employer can make to an employee’s SEP IRA is the lesser of 25% of the employee’s compensation or $69,000.
This may not be enough for some individuals to fully fund their retirement, especially if they have a high income or are trying to catch up on their savings.
Another disadvantage of a SEP IRA is that employee participation is not required. While employers are required to make contributions on behalf of eligible employees, employees are not required to contribute to their SEP IRA account.
This may not be beneficial for those who want to contribute more than the employer’s contribution, as they will not be able to do so within the SEP IRA.
Finally, SEP IRAs typically have limited investment options compared to other types of IRAs. SEP IRA funds can be invested in various options, but the selection may be more limited compared to other IRAs or employer-sponsored plans.
Who can have a SEP IRA?
There are two types of people who can participate according to the IRS: Employers and employees who meet specific criteria.
Employers can be:
- Small-business owners.
- Solo-entrepreneurs.
- Contractors with independent businesses.
Employees eligible are individuals who are:
- Age 21.
- Worked for their employer 3 out of the last 5 years.
- Received a minimum of $750 in compensation for the year.
- Have employers who have willing to open and contribute to a SEP IRA.
SEP IRA vs. Roth IRA
With a Roth IRA:
- You can’t deduct your contributions like you can with a SEP or traditional IRA.
- You deposit funds into a Roth IRA after you pay taxes upfront.
- Because you pay taxes upfront on the money you deposit, your investments grow tax-free.
- You can only use a Roth IRA if your gross income is below $214,000 for a married couple and less than $144,000 for someone who is single. These are new limits for 2024.
- You can only deposit up to $7,000 per year in a Roth IRA or $8,000 if you’re age 50 and older.
With a SEP IRA:
- According to the IRS, “The most you can deduct on your business’s tax return for contributions to your employees’ SEP-IRAs is the lesser of your contributions or 25% of compensation.” This is subject to a $330,000 compensation cap.
- You deposit funds into a SEP IRA before you pay taxes on it, so the tax is deferred until you make withdrawals in retirement.
- You can use a SEP IRA if you earn above $750 per year.
- SEP IRA contribution limits allow an employer to contribute up to 25% of compensation or $69,000, whichever is less, for 2024.
So, as you can see, a Roth and SEP IRAs are both retirement accounts but with very different rules. The biggest benefit of a Roth is that it’s a tax-advantaged account because you pay your taxes upfront.
However, a business owner benefits from SEP IRAs because they can deduct contributions (where permitted) on taxes, which is helpful when running a business with considerable expenses.
How to Open a SEP IRA
Saving for retirement is a wise idea, and it pays to take the time to research which investments you put inside the account will work best for your retirement goals.
There are many options when it comes to choosing where to open your SEP IRA as well. Several of the low-cost brokerage firms like Charles Schwab, Vanguard, and Fidelity offer SEP accounts as well as advisors to help you along the way.
Can I contribute to a SEP IRA and a 401k?
If you work a 9-5 job that offers a 401(k) plan, and you own your own business that’s completely separate from your 9-5 job, yes. As long as the two entities have no overlap, you can open a SEP IRA for your side business while still contributing to your 401(k) for your primary job.
Additionally, your employer may offer both a 401(k) and a SEP plan. If they do, just know that there are limits to the total contributions you can make, including your employer match. And, if you’re self-employed, you can have a solo 401(k) and a SEP IRA, but again, you’ll have to pay close attention to the total contributions to make sure they don’t exceed the limits.
Bottom Line
A SEP IRA is a retirement account predominately for entrepreneurs, solopreneurs, and small-business owners. They can be a great vehicle for saving for retirement. However, if you own multiple businesses or work a 9-5 in addition to having a side business, spend time doing your research to make sure you don’t exceed your contribution limits to ensure you don’t get penalized.
