How Does a Simplified Employee Pension (SEP) IRA Work?

A simplified employee pension (SEP) IRA is a retirement savings plan established by employers for the benefit of their employees and themselves. It can also be established by self-employed individuals. Employers can make tax-deductible contributions on behalf of eligible employees to their SEP IRAs.

SEPs are advantageous because they are easy to set up, have low administrative costs, and allow an employer to determine how much to contribute each year. SEP IRAs also have higher annual contribution limits than traditional IRAs. What’s more, employer contributions vest immediately.

How a SEP IRA Works

SEP IRA accounts are treated like traditional IRAs for tax purposes and allow the same investment options. They are an attractive retirement plan option for many business owners because they’re simple to set up and manage, low cost, and flexible. For example, a SEP IRA does not come with many of the start-up and operating costs that most conventional employer-sponsored retirement plans have. Plus, they have generous contribution limits and offer tax benefits.

Many employers also set up a SEP plan so that they can contribute to their own retirement at higher levels than a traditional IRA allows. Workers can open a SEP for a separate self-employed business even if they participate in an employer’s retirement plan at a second job.

Employers receive a tax deduction for the contributions they make to every employee’s SEP IRA account. Additionally, the business is not locked into an annual contribution. Decisions about whether and how much to contribute can change each year.

Another advantage for business owners is that they’re not responsible for making investment decisions. Instead, the IRA trustee determines eligible investments, and the individual employee account owners make specific investment decisions. The trustee also deposits contributions, sends annual statements, and files all required documents with the IRS.

Who Can Participate in a SEP IRA Plan?

According to IRS rules, you must be at least 21 years old, have worked for the employer in at least three of the previous five years, and have received a minimum of $750 in compensation from the employer during the current year to qualify for an employee SEP IRA.

Employers may exclude certain types of employees from participating in a SEP IRA, even if they would otherwise be eligible based on the plan’s rules. For instance, workers who are covered in a union agreement that bargains for retirement benefits can be excluded. So can workers who are immigrants without papers as long as they do not receive U.S. wages or other service compensation from the employer.

SEP IRAs were primarily designed to encourage businesses that would otherwise not set up employer-sponsored plans to offer retirement benefits to their employees. Sole proprietors, partnerships, and corporations can establish SEPs.

SEP IRA Contributions

One significant advantage of a SEP IRA is the amount that can be contributed annually. For 2023, contribution amounts can be up to the lesser of 25% of the employee’s compensation for the year or $66,000. The limit on compensation used to calculate the contribution is $330,000 for 2023.

This contribution limit is significantly higher than the $6,500 limit imposed on standard IRAs (even when including the extra $1,000 catch-up contribution allowed for anyone aged 50 or over).

The deadline for contributions is the tax filing deadline (plus extensions) of the company or self-employed individual who sets up the SEP IRA.

Pros and Cons of a Simplified Employee Pension (SEP) IRA

If you are looking to set up a SEP IRA or participate in one, consider the following pros and cons of a SEP: 

SEP IRA Pros

One of the main advantages of SEP IRAs is that they are easier to set up than other employer-sponsored plans, such as a 401(k), and they have lower operating costs. SEP IRAs have higher annual contribution limits than traditional and Roth IRAs. In addition, employer contributions vest immediately.

SEP IRA Cons

While contributions vest immediately, only employers can contribute to an employee’s account. How much an employer contributes is discretionary and can vary from year to year. For example, in a year when profits fall, an employer can choose not to contribute at all.

Also, employers who make contributions to their own account are required to contribute to each eligible employee’s account. The amount contributed must be the same to each employees’ account, including your own as an employer.

The Bottom Line

The administrative costs and burden of a SEP IRA is low when compared to other types of employer-sponsored retirement plans. This makes it a good option for many small businesses and self-employed people. In addition, contribution limits are high, particularly when compared to traditional or Roth IRAs, allowing retirement savers to put away more money.