Simplified Employee Pension (SEP) IRA: What It Is, How It Works

What Is a Simplified Employee Pension (SEP)?

A simplified employee pension (SEP) is an individual retirement account (IRA) that an employer or a self-employed person can establish. The employer is allowed a tax deduction for contributions made to a SEP IRA and makes contributions to each eligible employee’s plan on a discretionary basis.

Additionally, under the Setting Every Community up for Retirement Enhancement (SECURE) Act, enacted on Dec. 20, 2019, small employers get a tax credit to offset the costs of starting a 401(k) plan or SIMPLE IRA with automatic enrollment. That’s on top of the start-up credit they already receive.

SEP IRAs often have higher annual contribution limits than standard IRAs. In a sense, they're a cross between a traditional IRA and a 401(k). Like the latter, they can receive employer contributions, and, like the former, contributions are vested immediately.

How a Simplified Employee Pension (SEP) Works

A SEP IRA is an attractive option for many business owners because it does not come with many of the start-up and operating costs of most conventional employer-sponsored retirement plans. Many employers also set up a SEP IRA to contribute to their own retirement at higher levels than a traditional IRA allows.

Small organizations favor SEP IRAs because of eligibility requirements for contributors, including a minimum age of 21, at least three years of employment, and a $750 compensation minimum for 2024. In addition, a SEP IRA allows employers to skip contributions during years when business is down.

SEP IRAs are treated like traditional IRAs for tax purposes and allow the same investment options. The same transfer and rollover rules that apply to traditional IRAs also apply to SEP IRAs. When an employer makes a contribution to a SEP IRA account, it receives a tax deduction for the amount contributed. Additionally, the business is not locked into an annual contribution requirement; decisions about whether to contribute and how much can change each year. There is, however, an upper limit, which is $69,000 in 2024.

The employer is 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.

Immediate Vesting

Contributions to SEP IRAs are immediately 100% vested, and the IRA owner directs the investments. An eligible employee (including the business owner) who participates in their employer’s SEP plan must establish a traditional IRA to which the employer will deposit SEP contributions.

Some financial institutions require the traditional IRA to be labeled as a SEP IRA before they will allow the account to receive SEP contributions. Others might allow SEP contributions to be deposited to a traditional IRA regardless of whether the IRA is labeled as a SEP IRA.

SEP IRA Contribution Limits

Contributions made by employers cannot exceed the lesser of 25% of an employee’s compensation, or $69,000 in 2024. As with a traditional IRA, withdrawals from SEP IRAs in retirement are taxed as ordinary income.

When a business is a sole proprietorship, the employee-owner pays themselves wages and may also make a SEP contribution, which is limited to 25% of wages (or profits) minus the SEP contribution. For a particular contribution rate (CR), the reduced rate is CR ÷ (1 + CR) for a 25% contribution rate. This yields a 20% reduced rate.

Because the funding vehicle for a SEP plan is a traditional IRA, SEP contributions, once deposited, become traditional IRA assets and are subject to many of the traditional IRA rules, including the following:

• Distribution rules
• Investment rules
• Contribution and deduction rules for traditional IRA contributions as they apply to an employee’s regular IRA contributions, not the SEP employer contributions
• Documentation requirements for establishing an IRA

In addition to the documents required for establishing a SEP plan (discussed later), each SEP IRA must meet the documentation requirements for a traditional IRA.

SEP IRA Rules

SEP IRAs were primarily designed to encourage retirement benefits among businesses that would otherwise not set up employer-sponsored plans. Any small business can establish them, including sole proprietors, partnerships, and corporations (including S corporations).

Income Limitations

As for participants, too high an income can be a limitation—the 2024 eligible compensation limit is $345,000. However, unlike qualified retirement plans, the SEP does not allow participants, including the business owner, to borrow up to the lesser of 50% or $50,000 of their vested balance.

Employee Exclusion

Specific employees may be excluded by their employer from participating in a SEP IRA, even if they would otherwise be eligible based on the plan’s rules. For example, workers covered in a union collective bargaining agreement for retirement benefits can be excluded. Employees who are nonresidents can also be excluded as long as they do not receive U.S. wages or other service compensation from the employer.

Withdrawals and Contributions

SEP contributions and earnings are held in SEP IRAs and can be withdrawn at any time, subject to the general limitations imposed on traditional IRAs. A withdrawal is taxable in the year received. If a participant makes a withdrawal before age 59½, generally, a 10% additional tax applies.

Rollover and Distributions

SEP contributions and earnings may be rolled over to other IRAs and retirement plans tax-free. Additionally, SEP contributions and earnings must eventually be distributed following the IRA-required minimum distribution rules.

SEP IRA vs. Solo 401(k)

A SEP IRA and a solo 401(k), also known as an “individual 401(k),“ are both retirement accounts that allow employer contributions. However, they have two main differences.

The first is that although both accounts have the same maximum contribution limit ($69,000 in 2024), you can contribute the maximum to a solo 401(k) at a lower income level than a SEP IRA.

In 2024 individuals making $154,000 or more could reach the maximum for a solo 401(k).

 $23,000 employee contribution + $7,500 catch-up contribution 
+ $38,500 (25% of $154,000) employer contribution = $69,000 

SEP IRA owners, however, needed to make $276,000 or more to get the same amount.

 25% of $276,000 annual employee compensation = $69,000

Second, you can take a loan against the solo 401(k), which is not allowed with a SEP IRA.

A SEP IRA, however, is somewhat easier to set up and maintain. A solo 401(k) requires its owner to be more involved in its administrative responsibilities, and it can also generate higher fees than a SEP IRA.

SEP IRA vs. Traditional IRA vs. Roth IRA

There are important differences between these three retirement accounts.

Traditional IRA

With a traditional IRA, you contribute tax-free money, reducing your tax bill in the year you make the contribution. However, when you withdraw funds in retirement, they are taxed as ordinary income, and you are required to make distributions once you reach the age of 73 (up from 72 and 70½ in previous years). This makes it best for people who expect to be in a lower tax bracket when they retire.

Roth IRA

A Roth IRA reverses the process. You have already paid income tax on the money you contribute, so withdrawals in retirement are tax-free. This makes a Roth IRA better for people who expect to be in a higher tax bracket in retirement. In addition, there are no required minimum distributions from a Roth IRA, so if you don’t need the money, you can just let it sit there and pass the account on to your heirs.

SEP IRA

A SEP IRA is available to any employer, including self-employed persons. It allows employer contributions, which traditional and Roth IRAs do not, and all contributions to it are tax-free, meaning that distributions in retirement will be taxed as ordinary income. The maximum contribution limit for a SEP IRA is considerably higher than that for either a traditional or Roth IRA. Employers can get a tax deduction for their contribution, which means that when the self-employed person is both employer and employee, they can get that tax deduction. SEP IRAs were invented as a way to help small businesses provide employer-sponsored retirement plans to their employees and owners.

Frequently Asked Questions (FAQs)

The Bottom Line

A SEP IRA is a retirement plan option for small business owners and qualified employees. It has higher contribution and income limits than other retirement plans. To set one up, small business owners must choose a plan provider and make contributions. If they have employees, they are required to contribute to their plans equally.