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Retirement

Can A W-2 Employee Contribute To A SEP IRA?

If you're a W-2 employee, your employer may choose to offer a SEP IRA as an alternative to a full employer-sponsored 401k plan. As an employee, you cannot make direct contributions to a SEP IRA, like you could with a 401k.

A SEP IRA is like a simpler, more cost-effective alternative to offering a 401k plan. Smaller companies will usually choose this option because it's easier to set up and administer versus a 401k.

If you're an employee at a company that offers SEP IRA contributions to your account, here's everything you need to know about controlling, directing, and contributing to your account.

Can a W-2 employee contribute to a SEP IRA?

No, employees cannot make contributions into a SEP IRA. Only employers are allowed to contribute to a SEP IRA.

Employers are allowed to contribute up to 25% of their compensation, up to a maximum of $61,000 for 2022 and $66,000 for 2023. If an employer contributes to their account, they're obligated to make equal percentage contributions for every eligible employee.

For example, if your employer decides to contribute 5% of their compensation into their SEP IRA, they must also contribute 5% of your compensation into your SEP IRA. All employees and employers must receive equal percentage contributions. There must not be any difference in percentage of compensation that gets contributed.

If any employee receives a higher or lower percentage than the employer, corrections must be made by your employer.

Also read: What is a SEP IRA?

Who is an eligible employee?

The IRS deems any employee that meets the following requirements to be an eligible employee.

  • Is at least 21 years of age.
  • Has worked at the company for at least 3 of the past 5 years.
  • Earned at least $650 in 2022 or $750 in 2023.

Your employer is not obligated to make contributions every year, and they're allowed to decide how much of their compensation they'll contribute. If they're having a down year, they can decide not to contribute anything at all.

This is unfortunate for eligible employees because you're not allowed to make any contributions to your SEP IRA yourself. You can only receive contributions made from your employer. If they decide not to contribute for the year, no money gets contributed to your SEP IRA.

How do SEP IRA contributions work for employees?

When your employer opens a SEP IRA, they must also open accounts for every eligible employee. The account that gets opened for employees is a traditional IRA and your employer makes SEP contributions to it.

You're the owner of the traditional IRA that receives SEP contributions, and can decide how your funds get invested. All contributions made by your employer are immediately 100% vested and owned by you.

Because the account you're holding is a traditional IRA, you can still make IRA contributions to your account, even if you're a W-2 employee.

You can contribute up to $6,000 into a traditional IRA in 2022, and up to $6,500 for 2023. If you're at least 50 years of age, you also get an additional $1,000 in catch up contributions, bringing your total contribution limit to $7,000 for 2022 and $7,500 for 2023.

A traditional IRA allows anyone with earned income to make contributions, whether you're a W-2 employee or a contractor.

So while you can't make SEP IRA contributions as a W-2 employee, you can still make contributions into your traditional IRA, which would be tax deductible from your W-2 income.

SEP and traditional IRA contribution example

For example, if you make $50,000 this year, and decide to contribute $5,000 to your traditional IRA, your new taxable income would be $45,000 ($50,000 minus $5,000 contribution). Investments in your account grow tax-deferred until you take qualified distributions in retirement.

Let's take the example further with SEP contributions.

On top of your traditional IRA contribution, your employer may decide to contribute 5% of their compensation that year. If you're an eligible employee, you're also entitled to a 5% contribution of your compensation, which would be $2,500. Your employer would have to make SEP contributions of $2,500 into your SEP IRA (which is your traditional IRA).

The $2,500 would not be tax deductible because it is not an elective salary deferral. Only the $5,000 you contributed to your traditional IRA would be deducted from your taxable income that year.

When your employer makes the $2,500 contribution, that money is immediately 100% vested and owned by you. You could choose to invest that money however you like, or you could decide to rollover the money into another retirement account, like a solo 401k.

When can employees withdraw money from their SEP IRAs?

The SEP IRA withdrawal rules are the same for employers and employees. You can start taking qualified distributions when you turn 59½ years old. Any withdrawals before the age of 59½ are hit with a 10% penalty plus income taxes on the amount drawn.

59½ is the age you can start taking withdrawals without a penalty, but you're not required to withdraw from your account until you turn the age of 72, which is the RMD kicks in.

RMD stands for required minimum distribution and all retirement accounts, except the Roth IRA has an RMD rule. The RMD rule forces you to take distributions from your account each year once you turn 72 years old. It's calculated by your account balance as of December 31, the previous and is divided by your life expectancy score.

You must take your first RMD by April 1, the year after you turn 72 years of age. All future RMDs can be taken by December 31, each year.

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