- A SEP IRA is a tax-advantaged retirement account that allows self-employed workers and business owners to make tax-deductible contributions.
- Any small-business owner or self-employed worker can open a SEP IRA and contribute on behalf of themselves and their employees.
- You can contribute up to the lesser of 25% of your net income or $61,000 per year in 2022, with no catch-up contribution option if you’re 50 or older.
- Alternatives to a SEP IRA include a solo 401(k), a traditional IRA or a Roth IRA.
More than one in 10 American workers are self-employed, according to Pew Research Center, and for those roughly 16 million people, saving for retirement can be especially challenging. After all, you can’t simply sign up for your employer’s ready-made retirement savings plan and have contributions taken out of every paycheck automatically.
Fortunately, you can still put aside money in a tax-advantaged retirement account, including a SEP IRA. This account might be just the tool you need to start saving for retirement. Keep reading to learn more about how SEP IRAs work, who is eligible for one, how much you can contribute, their pros and cons, and more.
Inside this article
What is a SEP IRA, and how does it work?
A Simplified Employee Pension (SEP) IRA is a tax-advantaged retirement account that allows small-business owners to save for their own and their employees’ retirement.
When you fund a SEP IRA, your contributions are tax-deductible. You can invest the money in your account in stocks, bonds, mutual funds, cash and more, and your investments grow tax-deferred. Then when you take money from the account in retirement, you’ll owe income taxes on those withdrawals.
SEP IRAs have many of the same rules as other retirement plans like 401(k) plans and traditional IRAs. If you withdraw money before you turn 59½, you’ll be subject to a 10% early withdrawal penalty. And if you choose not to touch the money right away, you have to start taking what are called required minimum distributions when you turn 72. If you don’t, you will be subject to financial penalties.
Who is eligible for a SEP IRA?
Any business owner can open and contribute to a SEP IRA, whether you run a business with employees or are a self-employed freelancer or gig worker.
If you have employees, they can also participate in your business’s SEP IRA, and you must include your employees if they:
Are at least 21 years of age
Have worked for your business for three of the past five years
Have received at least $650 in 2022 and $600 in previous years
Employee contributions are a percentage of their salary. “The employer must contribute the same percent to each employee as is contributed to the employer’s SEP,” says Graham Miller, a Certified Financial Planner and lead advisor for Wiegand Financial Group. “For example, if Business Owner Bob contributes 10% of his income to a SEP, Bob must also contribute 10% worth of each of his employees’ income to their SEP IRAs.”
Another feature to know about: All SEP IRA contributions vest immediately, meaning the employee fully owns them. You can’t set up an extended vesting schedule as you can with other employer-sponsored plans.
SEP IRA contribution limits
The SEP IRA rules allow for generous contributions. The maximum amount you can contribute to your account each year is the lesser of:
25% of your compensation or
$61,000 in 2022 (up from $58,000 in 2021 and $57,000 in 2020)
Note that for purposes of determining SEP IRA contributions, your compensation isn’t all the money your business earns. Instead, it’s the amount that’s left after deductions (both business and personal).
One major difference between a SEP IRA and some other tax-advantaged retirement accounts is that SEP IRAs don’t allow for catch-up contributions for savers 50 and older.
How to set up a SEP IRA
Setting up a SEP IRA is a simple process that you can usually do in just a few minutes. To open one, you’ll have to complete IRS Form 5305-SEP. You don’t have to file this form with the IRS—instead, keep a copy and provide a copy to any plan participant.
If you’re opening a SEP IRA with a financial firm, they’ll complete this paperwork for you. Log in to any mutual fund company or online broker like Vanguard or Fidelity or a robo-advisor like Betterment. Once you select that you want to open a SEP IRA, the sites will guide you through the entire process.
If you want to include employees in your SEP IRA plan, you’ll have to open an account for each one or have them open their own. Each employee’s account can be set up with a financial institution of their choosing.
If you’re setting up a SEP IRA for yourself alone, it will operate the same as any other investment account, allowing you to log in to make contributions or set up automatic recurring contributions for any amount you want.
Pros and cons of a SEP IRA
SEP IRAs have some serious benefits, even when compared to tax-advantaged retirement accounts. But there are also some downsides to be aware of.
Pros of a SEP IRA
SEP IRAs are easy to set up and operate.
Contributions are tax-deductible, which means a lower tax bill any year you contribute. The funds in the account grow tax-deferred, and you won’t owe income taxes until you withdraw money in retirement.
The amount you can contribute to a SEP IRA can be considerably larger than what you can contribute to a traditional IRA, Roth IRA or 401(k) plan.
SEP IRAs are highly flexible—you can contribute in years when you have good cash flow but pause contributions during tough times.
Cons of a SEP IRA
If you have employees, you’ll have to make contributions to each of their accounts proportional to your contribution to your own account.
Like 401(k) plans and traditional IRAs, SEP IRAs have required minimum distributions starting at age 72.
There is no Roth option with a SEP IRA, so you can’t take advantage of this alternative approach to tax savings (contributions are in post-tax dollars, but retirement withdrawals are tax-free).
SEP IRA alternatives
A SEP IRA is just one of the many accounts available to help business owners save for retirement. You can also use these tax-advantaged accounts to save for retirement, either in addition to or instead of a SEP IRA.
A solo 401(k) is another popular retirement plan for self-employed workers and business owners. This account is like the 401(k) you might be offered through an employer, but it’s for business owners with no employees (that’s the “solo” part).
With a solo 401(k), you can contribute up to $20,500 as an employee in 2022, and then as the employer contribute up to 25% of your net self-employment income, for a total contribution limit of $61,000 in 2022 (the same as the contribution limit for a SEP IRA).
One major advantage of a solo 401(k) over the SEP IRA is that you can make an additional catch-up contribution of $6,500 per year if you’re 50 or older.
Another benefit is that you have the choice of making pre-tax contributions to a traditional 401(k) and paying income taxes on withdrawals, or putting post-tax dollars into a solo Roth 401(k) and enjoying tax-free income in retirement. That isn’t an option with a SEP IRA.
Ultimately, a solo 401(k) is a better option for many business owners, especially those who want to take advantage of the catch-up contributions or the Roth option.
Plus, if you’ve structured your business as an S corp, a solo 401(k) can make more sense. “A SEP requires that your contributions are based only on the self-employed portion of your income, but S corp owners split their income between self-employed earnings and business profits,” says Miller. “If you like to keep your self-employed earnings low for tax purposes—consult your accountant—then you would need to implement a solo 401(k) rather than a SEP if you wanted to hit the max contribution amount.”
When you have employees—or hope to—a solo 401(k) isn’t an appropriate option. Once you hire workers you won’t be able to contribute to your solo 401(k) any longer. A SEP IRA would be a better choice.
Another downside to these accounts is that they’re more complicated to set up. As with a SEP IRA, your broker can help you set up the paperwork. However, there may be more forms to fill out, and you may be responsible for annual filings, too.
Anyone with earned income can fund a traditional IRA. For a self-employed worker, the tax features are similar to a SEP IRA’s: You can deduct your contributions on your taxes, the funds in the account grow tax-deferred, and you’ll owe income taxes on your withdrawals during retirement.
The one major downside of a traditional IRA—and the reason a SEP IRA can be a better choice—is that the annual contribution limit is low: only $6,000 in 2022, or $7,000 if you are 50 or older.
Just as with a traditional IRA, you can contribute up to $6,000 to a Roth IRA in 2022, $7,000 if you are 50 or older. The major difference between a Roth and a traditional IRA or SEP IRA is when you enjoy the biggest tax advantage.
In the case of a SEP IRA or traditional IRA, you get a tax benefit the year you make the contribution because contributions are tax-deductible. Then the money grows tax-deferred, and you pay taxes on your withdrawals during retirement. With a Roth IRA, you contribute after-tax dollars, meaning there’s no up-front tax benefit. But then the money grows tax-free, and you can withdraw it tax-free during retirement.
A Roth IRA can be an attractive addition to a SEP IRA, thanks to its unique tax advantage. However, you may not want to invest only in the Roth IRA due to its low contribution limit.
Can you invest in more than one retirement account?
The short answer is yes, you can contribute to more than one retirement account. For example, you might have a 401(k) at your day job and use a SEP IRA to set aside money from the side hustle you run.
Where it gets tricky is if both retirement plans are from the same employer. “Technically, you can contribute to other retirement accounts in addition to a SEP IRA,” says Miller. “However, if those other accounts are through the same employer, then the contribution limit applies to your total contributions across all those accounts, rather than to each account individually.”
The good news is that if the plans aren’t offered by the same employer, you can contribute up to the full limit for each plan. Additionally, just as you can contribute to a 401(k) plan and an IRA, you can also contribute to both a SEP IRA and a traditional or Roth IRA up to the full limit. The only consideration is that depending on your income, having a SEP IRA could limit your ability to deduct your entire traditional IRA contribution.