SEP IRAs for Self-Employed and Small Business Owners

Is a SEP IRA retirement plan right for your business?

Self employed person saving for retirement.
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A Simplified Employee Pension, or a SEP IRA, is a type of retirement plan. It can be established by a self-employed person or small business owner.

Learn more about SEP IRAs and how they work.

Key Takeaways

  • A SEP IRA can be useful for deferring income, saving for retirement, and saving money on taxes.
  • You can contribute up to 25% of your earned income to a SEP IRA, with a maximum of $58,000 per year as of 2021.
  • You must contribute the same percentage of income for eligible employees as you do for yourself.
  • However, you're not required to make contributions every year.

Who Might Want to Establish a SEP?

A high-income earning self-employed person with no employees might consider setting up a SEP IRA. It can be useful for deferring income, saving for retirement, and saving money on taxes. For self-employed people with no employees, it may be best to compare a SEP to an Individual 401(k) plan to decide which plan is best for you.

Note

The Individual 401(k) may allow you to switch between Roth 401(k) (after-tax) and Regular 401(k) (pre-tax) contributions. It all depends on your tax bracket. The SEP, on the other hand, only accepts pre-tax contributions.

An employer who wants to reward loyal employees might consider a SEP as an alternative to a more formal profit-sharing plan. The SEP will have lower administrative fees and lower costs. It will also be more flexible.

How Much Can You Contribute to a SEP?

You can contribute up to 25% of your earned income. This is your net income after business expenses. There's a maximum contribution of $58,000 in 2021.

How Much Do You Have to Contribute for Employees?

You must contribute the same percentage of income for your employees as you do for yourself. For instance, let's say you contribute 20% of your eligible compensation to the plan. In that case, you must also make a contribution for each eligible employee in the amount of 20% of their eligible compensation.

Employees are eligible for contributions if:

  • They have worked for you three out of the past five years.
  • They earn more than $650 in 2021.
  • They are age 21 or older.

You have until your tax filing deadline (plus extensions) to make contributions to your SEP for the previous year. The IRS has a great section on SEP IRAs that covers additional rules.

How Do You Set Up a SEP?

There are a few steps for setting up a SEP. You establish it by executing a written agreement and setting up the SEP with a qualified financial institution. This could be a bank, mutual fund company, or brokerage firm; you could also go through a financial advisor. Then, you open a SEP IRA for each eligible employee.

You must notify employees that you have established a plan. You also must inform them of the eligibility criteria.

In addition to any employer contributions, employees may make their regular IRA contributions to their SEP IRA. The deductibility of their IRA contribution is subject to the normal IRA deductibility rules; these are based on their gross income. It also depends on whether they participate in an employer-sponsored plan. The SEP does count as an employer-sponsored plan.

What Are the Advantages of SEPs?

SEPs have a variety of advantages. These include the following:

  • Employers are not required to make contributions each year. The amount of contribution as a percentage of income can vary from year to year.
  • No excess tax forms are required. With a 401(k) plan, an annual Form 5500 must be filed. This is not required for a SEP.
  • The employer chooses the financial institution that holds the SEP accounts. But each employee is responsible for choosing their own investments inside the account. This is an advantage for the employer; the employer is not responsible for the underlying investments.
  • SEPs are great for people who have a side gig. That's because it allows the worker to fully contribute to their employer's 401(k) plan and use a SEP IRA for self-employment income.

What Are the Disadvantages of SEPs?

SEPs have a few disadvantages for small business owners as well. These include:

  • Employees are 100% vested in employer contributions once they are made. No vesting schedule may be attached to SEP contributions. If an employee leaves the day after the contribution is made, it is theirs. In addition, let's say they leave part-way through the year and you make a contribution for that calendar year. In that case, you must make a contribution for them based on the amount of eligible compensation they had up until the time they left.
  • You must make the same percentage contribution for all eligible employees. In a formal profit-sharing plan, you can classify employees into groups and have the ability to make different contribution amounts for different groups.