What Is a Simplified Employee Pension Plan? How SEP IRAs Work

A Simplified Employee Pension IRA (SEP IRA) is a traditional IRA for self-employed people and small-business owners.
Arielle O'Shea
By Arielle O'Shea  
Updated
Edited by Chris Hutchison  

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What is a SEP IRA?

A SEP IRA reads like a mess of letters, and spelling it out doesn’t necessarily help: The first part stands for simplified employee pension; the second for individual retirement account.

Translation: A SEP IRA is a basic individual retirement account, much like a traditional IRA. SEP IRAs are for business owners, and contributions are tax-deductible. Investments grow tax-deferred until retirement, when distributions are taxed as income.

SEP IRA contribution limits

A traditional IRA allows you to put away up to $6,000 in 2022, and $6,500 in 2023. For those 50 and older, you can contribute an additional $1,000 both years. With a SEP IRA, you can stockpile nearly 10 times that amount, or up to $61,000 in 2022, and $66,000 in 2023. However, SEP IRA annual contribution limits cannot exceed the lesser of:

  • 25% of compensation.

  • $61,000 in 2022 and $66,000 in 2023.

The first limit, 25% of compensation, is also the limit for how much you can contribute for each eligible employee. The amount of compensation you can use to calculate the 25% limit is limited to $305,000 in 2022 and $330,000 in 2023.

There's no catch-up contribution at age 50 and older for SEP IRAs.

SEP IRA rules: Who is eligible?

Generally, SEP IRAs are best for self-employed people or small-business owners with few or no employees. Here's why: If you have employees whom the IRS considers eligible participants in your plan, you must contribute on their behalf, and those contributions must be an equal percentage of compensation to your own.

  • Eligible participants are employees who are 21 or older, have worked for you for at least three of the past five years, and have made a minimum of $650 in 2022 or $750 in 2023. For example, if an employee worked for you in 2019, 2020 and 2021 and made $850, you would need to make a contribution for them for the 2023 plan year.

  • If you want to stash away 15% of your compensation for yourself, you must also contribute 15% of that employee's compensation to their plan. Note that this is just an example — SEP IRAs are subject to contribution limits listed above.

  • Employees own and control their own accounts.

Because of that rule requiring equal contributions as a percentage of compensation, a SEP IRA is generally best for self-employed people or small-business owners with few or no employees.

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How does a SEP IRA work? The pros and cons

PROS

CONS

  • That high contribution limit of up to $61,000 in 2022 and $66,000 in 2023.

  • Easy to set up and administer.

  • Can be combined with a traditional IRA or a Roth IRA.

  • Contributions are tax-deductible, including those made to employee accounts. You can deduct the lesser of your contributions or 25% of compensation, subject to the compensation cap ($305,000 in 2022 and $330,000 in 2023). If you’re self-employed, your deduction is 25% of net self-employment income.

  • Flexibility: You don't have to commit to contributing every year.

  • No catch-up contribution for savers 50 or older.

  • No Roth version, which means you can't opt to pay taxes on contributions now and take distributions tax-free in retirement, as you can by choosing a Roth IRA.

  • Required proportional contributions for each eligible employee if you contribute for yourself.

  • Like traditional IRAs and 401(k)s, SEP IRAs require minimum distributions. Beginning in the year 2023, these must start at age 73.

  • Also like a traditional IRA, distributions before age 59½ are taxed as income and subject to a 10% penalty, unless the reason for the distribution satisfies one of the early withdrawal exceptions.

How do I open a SEP IRA?

It's easy to open a SEP IRA account online. The first step is to choose an account provider. Here are our top picks for best IRA account providers.

Then, the IRS outlines three steps for setting up your SEP IRA:

  1. Create a formal written agreement. You can do this with IRS Form 5305-SEP or through your account provider.

  2. Give eligible employees information about the SEP IRA. You can give them a copy of IRS Form 5305-SEP or get similar information through your account provider.

  3. Set up separate SEP IRAs for each eligible employee with the account provider.

How do I invest my SEP IRA?

Once you’ve opened the account, you can choose from the investments your account provider offers. The selection typically includes stocks, bonds and mutual funds. (It's possible to open an IRA at a bank, but generally you'll be limited to investing in certificates of deposit, which usually offer a lower return than a diversified group of stocks and bonds.)

» Want more IRA investing lessons? Read our post on how to invest your IRA.

Once the account is open and funded, you’ll want to invest it according to your age, planned retirement age, and risk tolerance. If you have a fairly strong stomach for market swings and a long time until retirement, consider swaying your investment selection toward stocks, specifically stock index funds, which track a segment of the market and hold a diverse mix of stocks within that segment.

The less time you have until retirement — and the less patience you have for a market downturn — the more you might want to allocate toward bonds and bond funds. You can also buy index funds for bonds.

» Thinking about the future of your business? Learn about succession planning.

SEP IRA vs. Roth IRA

Both a SEP IRA and Roth IRA offer tax benefits when you retire. The main difference between a SEP and Roth IRA is that SEP IRAs offer tax-deferred growth on your investments, while Roth IRAs give you tax-free growth and withdrawals in retirement.

Contributions to SEP IRAs are tax deductible. You can't deduct contributions from a Roth, because you already paid taxes on the money before adding it to your account. Another major difference between a SEP and Roth account is that you can include employees in a SEP IRA and make contributions for them. You can't do that with Roths, and they may be better for self-employed individuals for that reason.

SEP IRAs also have higher contribution limits (up to $61,000 in 2022 and $66,000 in 2023) than Roth IRAs ($6,000 in 2022 and $6,500 in 2023). The bottom line is, both accounts can be suitable for business owners. It's just that they have different types of tax advantages, and SEP IRAs may be more suitable for companies with multiple employees.

SIMPLE IRA vs. SEP IRA

A SIMPLE IRA or Savings Incentive Match Plan for Employees is a retirement savings plan for employers and self-employed people. Some of the eligibility requirements include having no more than 100 employees who earned at least $5,000 in the previous year. The main difference between a SIMPLE IRA and a SEP IRA is that only employers are allowed to contribute to SEP IRAs, but employees can contribute to SIMPLE IRAs through their paycheck via elective deferrals.

Another core difference is that the SIMPLE IRA employee contribution limit is $14,000 in 2022, with a $3,000, catch-up contribution. In 2023, those numbers are $15,500, with a $3,500 catch-up for those 50 and older. The SEP IRA contribution limit is up to $61,000 for 2022 and $66,000 in 2023.

» Read more about SIMPLE IRAs

Frequently asked questions

Once you’ve opened the account, you can choose from the investments your account provider offers. The selection typically includes stocks, bonds and mutual funds. (It's possible to open an IRA at a bank, but generally you'll be limited to investing in Certificates of Deposit, which usually offer a lower return than a diversified group of stocks and bonds.)

» Want more investing guidance? Read our post on how to invest your IRA.

Once the account is open and funded, you’ll want to invest it according to your age, planned retirement age and risk tolerance. If you have a fairly strong stomach for market swings and a long time until retirement, your investment selection should sway toward stocks, specifically stock index funds, which track a segment of the market and hold a diverse mix of stocks within that segment.

The less time you have until retirement — and the less patience you have for a market downturn — the more you’ll want to allocate toward bonds and bond funds. You can also buy index funds for bonds.

» Thinking about the future of your business? Learn about succession planning.

You can combine a SEP IRA with a traditional or Roth IRA. If you’re an employee who is covered by a SEP IRA, employer contributions don’t reduce the amount you can contribute to an IRA for yourself, but the amount of your traditional IRA contribution that you can deduct may be reduced at certain higher income levels, due to the combination of both plans. (For more on that, see our post on IRA contribution limits.)

The government places no restrictions on contributing to both a SEP IRA and a traditional IRA in the same year. Also note you do not need to reduce your SEP IRA contribution to also contribute to a traditional IRA.

However, there are income limits to deducting contributions to a traditional IRA. Those with workplace retirement plans can only take the full deduction on a traditional IRA if their income is less than $68,000 in 2022 and $73,000 in 2023.

If you exceed the income limits and aren't eligible for a traditional IRA deduction, you could roll the funds from your traditional IRA into a Roth IRA using the backdoor Roth method. You can read our backdoor Roth article to learn more about how this works. By rolling over your funds into a Roth, you can enjoy tax-free distributions assuming you wait until your full retirement age.

The catch is that the government requires all rollovers from traditional to Roth IRAs be done on a pro-rata basis. This means that if you have an account with a $56,000 SEP IRA contribution and a $6,000 nondeductible traditional IRA contribution, you cannot choose to just rollover the $6,000. If you rolled over $6,000 (9.7% of all of the $62,000 total), the government would treat that like you were rolling over $5,418 (or 9.7%) of the SEP and $582 (also 9.7%) of the non-deductible traditional IRA, which is not what you intended at all. Unfortunately, you don’t have the option of designating which dollars are getting rolled over.

The only way to rollover the full non-deductible amount into a Roth IRA would be to rollover all of your traditional assets (this includes the full value of your SEP IRA and other traditional IRA accounts)

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