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.

SEP

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 small-business owners 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 it work?

It works similarly to a traditional IRAs. Business owners 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 the business owner pays for this contribution; 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 for 2019

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 $56,000 for 2019 – 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 $56,000, 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.

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 $600 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 $193,000 or below for a married couple and $122,000 or less for someone who is single. These are new limits for 2019.
  • You can only deposit up to $5,500 per year in a Roth IRA or $6,500 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 $275,000 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 are self-employed, own a small business, or are an independent contractor who earns above $600 per year.
  • You can deposit up to 25% of your compensation or $56,000, whichever is less, for 2019.

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, business owners benefit from SEP IRAs because you can deduct your contributions (where permitted) on your 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.