What Is a SEP IRA & How Does It Work?
With the impact of the pandemic and the expansion of the gig economy, more individuals are turning to self-employment and entrepreneurship to earn an income. For small-business owners or freelancers, many employer-sponsored retirement savings options are off the table.
Fortunately, SEP-IRA plans can provide a creative option that allows small-business owners to save for retirement without the need for a traditional IRA plan. These accounts have low fees and high contribution limits, giving non-traditional workers a way to save even more towards retirement.
What Is a SEP IRA?
A SEP-IRA is a specialized type of retirement account specific to business owners and self-employed individuals. The acronym SEP-IRA stands for Simplified Employee Pension Individual Retirement Account. This account follows many of the same rules and limitations as a traditional IRA account, but it has a few special provisions that make it especially helpful for small-business owners and the self-employed.
The key differences between a traditional IRA and a SEP-IRA include:
- SEP-IRAs have higher contribution limits
- Employer contributions to a SEP-IRA are optional
- Only employers can make contributions to a SEP-IRA, whereas both employers and employees can make contributions to a traditional IRA
- There are very minimal account fees associated with SEP-IRAs
How Does a SEP-IRA Work?
Once a SEP-IRA has been established, the employer contributes a designated percentage to the accounts of all eligible employees. If, for example, a business owner decided to contribute 10 percent of the CEO's salary to the SEP-IRA for the year, all other eligible employees would also receive 10 percent of their designated salaries. An employer can opt to make no contributions to the SEP-IRA for a given year, or select a contribution percentage to allocate, if desired, as long as all eligible employees receive the same contribution percentage.
SEP-IRA accounts are tax-deferred, meaning that all contributions are made on a pre-tax basis and are taxed when the funds are withdrawn from the account (typically after retirement age). Unlike some other retirement accounts, SEP-IRA accounts do not offer the option to pay taxes on the front end when the contributions are made.
What Are the Rules & Requirements for SEP-IRA?
Since a SEP-IRA is a tax-deductible retirement plan organized by the IRS tax code, there are several rules and requirements that must be followed to participate in the plan. If your business initiates a SEP-IRA plan without following the designated SEP-IRA requirements, the business can be subject to fines and penalties.
Contributions to a SEP-IRA must be made across the board for all eligible employees within the company. In order to be eligible for SEP-IRA contributions, an employee must meet the following criteria:
- Be at least 21 years of age
- Earn more than $650 a year from the employer
- Have worked for the company for at least three of the previous 5 years
Once a SEP-IRA is established by an organization through a written agreement, all employees who meet the eligibility criteria must be set up with a SEP-IRA unless they specifically elect to forgo an account. Since the contribution percentage for a given year must be equal for all eligible employees, SEP-IRA plans are generally more advantageous for businesses with few full-time employees or for self-employed individuals.
SEP-IRA Withdrawal & Distribution Rules
Distribution rules for SEP-IRA plans follow the same IRS restrictions as traditional IRA plans. Although employees cannot make contributions to a SEP-IRA, each employee maintains control of the account and any funds in it. The employee can make withdrawals at any time, but any distributions taken before age 59 ½ are typically subject to a 10 percent early withdrawal penalty.
Once an employee reaches age 72, they are subject to the standard required minimum distribution rules and must start taking minimum withdrawals from the SEP-IRA account. Failing to take the Required Minimum Distributions (RMDs) timely may generate penalties.
SEP-IRA Contribution Limits & Rules
The most important contribution rule for a SEP-IRA is that employers must contribute the same percentage for each eligible employee. Other SEP IRA contribution rules also apply to this type of retirement account. Employers can change the contribution percentage from year to year – or even elect to make no contributions at all – as long as the percentage is consistent for all eligible employees.
Because of this flexibility, many self-employed individuals and small-business owners use SEP-IRAs as a simple way to save for their own retirement, since the annual contribution limits are much higher than those for traditional IRAs. If an employer elects to make contributions in a given year, they can contribute the lesser of 25 percent of each employee's gross compensation (up to the maximum compensation of $305,000 for 2022) or the annual maximum dollar limit set by the IRS.
- For 2021, the IRS annual contribution limit is $58,000.
- For 2022, the IRS annual contribution limit is $61,000.
SEP-IRA Deduction Rules
Another employer benefit of offering these plans is that any SEP-IRA employer contributions are tax-deductible, up to the SEP limits specified by the IRS. If a business adds more than the specified contribution limits to an employee's account (also known as excess contributions), those amounts must be distributed from the affected employee’s SEP IRA and returned to the employer. They are not deductible on the employer's federal taxes. If not corrected timely, there may be excess contribution penalties as well.
Employers also have some flexibility with when to take a SEP-IRA tax deduction for any plan contributions. Contributions made between the end of a tax filing year and the time the taxes are filed can be claimed in either year. For example, if contributions are made in February 2022, those amounts are deductible in either the 2021 tax year (if 2021 taxes had not yet been filed) or the 2022 tax year (since that is the year in which the contributions were made).
SEP-IRAs & Taxes
SEP-IRA contributions are tax-deductible for the employer, so the employer would itemize and claim any eligible contributions on the annual business tax return. Since the employer receives SEP-IRA tax benefits and contributions are made to the accounts on a pre-tax basis, contributions are not listed on an employee's individual W2 form. Instead, any tax implications to the employee would be made when money is withdrawn from the SEP-IRA account, and the account provider would issue a 1099-R to the employee to report any taxable distributions.
Setting Up a SEP-IRA
If you decide that a SEP plan is right for your business, the steps for setting up your plan are relatively simple.
- Complete the formal written agreement paperwork to initiate the SEP-IRA
Typically this involves completing IRS Form 5035-SEP, though other IRS-approved documents or individual formal agreement documentation can be used in place of Form 5035-SEP. The completed documentation is not sent to the IRS but is kept on file with the employer as the official notice for all employees who are eligible to participate in the plan.
- Share plan information with all eligible employees
SEP IRA rules require the employer to contribute the same percentage of compensation for all eligible employees. You can share the information with employees by simply providing a copy of the IRS Form 5035-SEP or by sharing equivalent documentation that includes eligibility criteria, contribution amounts, and instructions for accessing and managing their individual accounts.
- Choose a SEP-IRA provider and set up accounts for all eligible employees
There are a number of brokers or account providers that can set up individual accounts for you and your employees. Each provider has access to different investment options, fee structures, and account minimums. Be sure to review and compare the provider offerings, then have your chosen provider start each account you need.
What Are the SEP-IRA Advantages & Disadvantages?
SEP retirement plans can be beneficial to both employers and employees. To determine if a SEP-IRA is right for your business, you should consider the following advantages and disadvantages.
Advantages of SEP-IRA:
- Easy to set up and manage for employees and employers/business owners
- Contributions are tax-deferred for the employee and tax-deductible for the business
- Annual contribution limits are higher than with traditional IRAs
- Employers have greater flexibility on contribution percentages from year to year
Disadvantages of SEP IRA:
- No employee contributions are allowed
- No catch-up contributions are allowed
- Any distributions taken before age 59 ½ are subject to a 10 percent tax penalty for the employee
For guidance with initiating a SEP-IRA for your business, talk to a retirement specialist.