What Is a SEP IRA? How SEP IRAs Work

A Simplified Employee Pension IRA (SEP IRA) is a traditional IRA for self-employed people & small-business owners.
Jan 5, 2022

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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: It’s a retirement account that offers tax breaks for business owners and self-employed individuals who put money away for the future.

What is a SEP IRA?

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 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 a minimum of $600 from you in 2016-2020 or $650 in 2021. For example, if an employee worked for you in 2019, 2020 and 2021 and made $750, you would need to make a contribution for him or her for the 2022 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 his or her plan. Note that this is just an example — the SEP IRA contribution limits for 2021 and 2022 are listed below.

  • 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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SEP IRA contribution limits

A traditional IRA allows you to put away $6,000 each year (that's the annual maximum in both 2021 and 2022; it's $7,000 if you’re 50 or older). With a SEP IRA, you can stockpile nearly 10 times that amount, or up to  $58,000 in 2021 and $61,000 in 2022. However, SEP IRA annual contribution limits cannot exceed the lesser of:

  • 25% of compensation

  • $58,000 in 2021 and $61,000 in 2022.

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 $290,000 in 2021 and $305,000 in 2022.

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

» Are you on track for retirement? Check our retirement calculator

Can I have a SEP IRA and a Roth IRA?

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.)

Can I Contribute to Both a SEP IRA and Traditional IRA?

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 $64,000 ($103,000 if married and filing jointly).

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)

How does a SEP IRA work? The pros and cons

PROS

CONS

  • That high contribution limit of up to $58,000 in 2021 and $61,000 in 2022.

  • 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 ($290,000 in 2021; $305,000 in 2022.). 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 at age 72.

  • 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 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.

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