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 SEP IRA is a retirement plan that a self-employed person or small business owner can establish.

Who Might Want to Establish a SEP?

A high income earning self-employed person with no employees might consider setting up a SEP IRA to defer income, save for retirement, and save money on taxes. For self-employed people with no employees, first, compare a SEP to an Individual 401(k) plan to decide which plan is best for you. The Individual 401(k) may allow you to switch between Roth 401(k) (after-tax) and Regular 401(k) (pre-tax) contributions based on your tax bracket. The SEP 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, lower costs and 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) with 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 example, if you contribute 20% of your eligible compensation to the plan 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
  • Earn more than $650 in 2021
  • 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?

You establish a SEP by executing a written agreement, setting up the SEP with a qualified financial institution (such as a bank, mutual fund company, brokerage firm or through a financial advisor) and opening a SEP-IRA for each eligible employee.

You must notify employees that you have established a plan and let them know 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, based on their gross income and whether they participate in an employer-sponsored plan. The SEP does count as an employer-sponsored plan.

SEP Flexibility and Advantages

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

SEP Disadvantages

  • 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, if they leave part-way through the year, and you make a contribution for that calendar year, 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.