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Retirement

What Is A SEP IRA? (How It Works, Rules, Eligibility)

SEP IRA Overview & FAQ

  • What is a SEP IRA? A SEP IRA is an individual retirement account designed specifically for business owners and self-employed individuals. Contribution limits are 10x higher than a traditional IRA.
  • What is the contribution limit of a SEP IRA? Employers can contribute up to 25% of their compensation up to $61,000 for 2022 and $66,000 for 2023.
  • When is the contribution deadline? Employers must make contributions by the federal tax filing deadline. For 2022, the tax filing deadline is April 18, 2023.
  • Who can contribute to a SEP IRA? Self-employed individuals and business owners with or without employees can contribute to a SEP IRA. If you have eligible employees, you must also make equal contributions to every employee's SEP IRA.
  • What are the tax benefits of a SEP IRA? Contributions to a SEP IRA are tax deductible. Investments in your account grow tax-deferred until you start taking distributions in retirement.
  • When can I withdraw from a SEP IRA? You can start taking qualified distributions from your SEP IRA when you reach the age of 59½. Any earlier withdrawals are hit with a 10% penalty plus income taxes. You're also required to start taking minimum required distributions each year once you turn 72 years old.

What is a SEP IRA?

A SEP IRA stands for Simplified Employee Pension and is an individual retirement account for business owners and self-employed individuals. You can think of it as a traditional IRA, but supercharged with higher contribution limits. Employers can contribute to their own accounts, as well as make contributions for any eligible employees in their business. 

  • A traditional IRA has a contribution limit of just $6,000 ($7,000 if age 50+) for 2022 and $6,500 ($7,500 if age 50+) for 2023.
  • A SEP IRA has a contribution limit of $61,000 for 2022 and $66,000 for 2023. That’s over 10x higher than a traditional IRA.

Like a traditional IRA, a SEP IRA is funded with pre-tax dollars. Contributions are tax-deductible and withdrawals in retirement are taxed as regular income.

A SEP IRA is easy to set up, requires little administration, and allows business owners to provide a simpler, more cost-effective retirement plan for their employees. As an employer, you have the freedom to choose how much you want to contribute each year, and can even skip contributions altogether if you have a down year.

12 Basic Rules of a SEP IRA

  1. Business owners and self-employed individuals can open and contribute to a SEP IRA.
  2. All business structures are eligible.
  3. Unlike a solo 401k, you are allowed to have full-time W-2 employees with a SEP IRA.
  4. Employers can contribute 25% of their compensation up to a maximum of $61,000 for 2022 and $66,000 for 2023.
  5. Employer contributions are tax-deductible. Investments in your account grow tax-deferred until you start taking distributions in retirement.
  6. Employees cannot make direct contributions to a SEP IRA.
  7. Employers must make equal percentage contributions to every employee's SEP IRAs. For example, if you contribute 10% of your compensation to your SEP IRA, you must also contribute 10% of every eligible employee's salary into their SEP IRAs.
  8. An eligible employee is any employee who is over 21 years of age, worked at the company for at least 3 out of the last 5 years, and earned at least $650 for 2022 and $750 for 2023.
  9. For employees, contributions made to their accounts by their employers are always 100% vested.
  10. Employees have full ownership and control over their SEP IRAs.
  11. You can start taking qualified distributions from your SEP IRA when you reach the age of 59½. Qualified distributions are taxed as regular income. Early withdrawals are hit with a 10% penalty, plus income taxes.
  12. A SEP IRA has required minimum distributions (RMD). You must start making withdrawals from your account each year when you reach the age of 72.

Who is eligible for a SEP IRA?

Business owners with businesses of any size, and self-employed individuals with or without employees, can open and contribute to a SEP IRA.

You're eligible for a SEP IRA if you:

  • are self-employed.
  • own a business.
  • employ others.
  • earn freelance income.

You can have zero employees, or you can have hundreds of employees and still be eligible for a SEP IRA. However, because of how a SEP IRA works, it’s best suited for business owners with just a few employees.

Do I need to be incorporated?

No. Any business entity can open and contribute to a SEP IRA. Sole proprietorships, partnerships, LLCs, and corporations are all eligible for a SEP IRA.

How does a SEP IRA work?

With a SEP IRA, employers can make tax-deductible contributions. Only employers can contribute to a SEP IRA; employees are not allowed to directly contribute.

Employers can contribute up to 25% of their compensation, up to a maximum of $61,000 for 2022 and $66,000 for 2023.

As an employer, you must also make equal percentage contributions for each eligible employee. For example, if you decide to contribute 25% of your compensation into your SEP IRA, you must contribute 25% of every eligible employee's salary into their SEP IRAs as well.

Who is an eligible employee?

An eligible employee is any individual who meets all of the following requirements:

  • Is at least 21 years of age.
  • Has worked for you for at least 3 of the last 5 years.
  • Made at least $650 in compensation for 2022 or $750 in compensation for 2023.

If any employees meet these requirements, you're required to make equal percentage contributions to their SEP IRAs. While employees cannot make contributions to their accounts, they still own and control their own SEP IRA accounts. Contributions made to their accounts are always immediately 100% vested.

Because employers must make equal percentage contributions for every eligible employee, a SEP IRA can get very expensive if you have too many employees. It's generally best suited for business owners with zero or just a few employees. However, if you have zero employees, you also qualify for a solo 401k, which has even more tax benefits than a SEP IRA.

SEP IRA contribution limits

Employers can contribute up to 25% of compensation up to a maximum of $61,000 for 2022 and $66,000 for 2023. There are no catch up contributions for people 50 years or older with a SEP IRA. The maximum amount of compensation you could use to calculate the 25% is limited to $305,000 in 2022 and $330,000 in 2023.

In comparison, a traditional IRA only has a contribution limit of $6,000 for 2022 and $6,500 for 2023. A traditional IRA does have catch up contributions. If you're 50 years of age or older, you can contribute up to $7,000 for 2022 and $7,500 for 2023.

Only employers can contribute to a SEP IRA, and all contributions are tax-deductible. Investments are tax-deferred until retirement, and qualified distributions are taxed as regular income.

Does a SEP IRA have allow Roth contributions?

A SEP IRA does not have the option for Roth contributions. There is no such thing as a Roth SEP IRA. If you have a SEP IRA, you can also contribute to a Roth IRA if you want to invest through a Roth account.

If you have zero full time employees, you can opt to open a solo 401k instead, which does have a Roth option.

Do I need to contribute every year?

The good thing about a SEP IRA is that contributions are not mandatory. You can choose your contribution amounts each year, and you can even choose not to make any contributions if you have a down year.

SEP IRA contribution deadline

Business owners must contribute to a SEP IRA by the federal tax filing deadline, which is April 15 most years. For 2023, the tax filing deadline is April 18, 2023.

When can you withdraw?

The withdrawal rules of a SEP IRA are the same as a traditional IRA. You can start taking qualified distributions from your account when you reach the age of 59½. Any early withdrawals are hit with a 10% penalty plus income taxes on the amount drawn.

Required minimum distributions

A SEP IRA also has required minimum distributions (RMD). You must start taking distributions every year, once you turn 72 years of age. Penalties for not taking an RMD are 50% of the amount you were supposed to withdraw.

What can I invest in with a SEP IRA?

Investments work similarly to any other IRA, like a traditional IRA or Roth IRA. Your investment options are limited to whatever selection is provided by the account provider that you choose to go with. You can typically invest in things like individual stocks, bonds, mutual funds, and ETFs.

There's also the option to open a self-directed account, which would give plan participants the option to invest in alternative assets like real estate and cryptocurrencies.

SEP IRA vs solo 401k

For employers, a SEP IRA can almost be viewed as a second-best option from the solo 401k. The solo 401k has many more tax-advantages including a Roth option, more investment freedom, catch-up contributions, and the ability to take out a loan up to $50,000 from your account.

The contribution limits are the same but, because a solo 401k allows employee contributions, you can max out the contribution limit of a solo 401k with less income than you could with a SEP IRA.

The downside is that, with a solo 401k, you cannot have any full-time W-2 employees that work over 1,000 hours in your business each year (excluding your spouse). Once you start hiring employees, a SEP IRA is the next best option.

SEP IRA vs traditional IRA

A traditional IRA and SEP IRA are very similar in tax treatments, withdrawal rules, and investment options. For both accounts, you can contribute pre-tax dollars and get a tax-deduction. Investments grow tax-deferred until retirement, and you could start taking qualified distributions when you reach the age of 59½. Withdrawals in retirement are taxed as regular income.

A SEP IRA has a contribution limit of $61,000 for 2022 and $66,000 for 2023. A traditional IRA only has a contribution limit of $6,000 ($7,000 if age 50+) for 2022 and $6,500 ($7,500 if age 50+) for 2023.

A traditional IRA can be opened by anyone with earned income. A SEP IRA can be opened by business owners and self-employed individuals. If you only earn income through an employer, you're only allowed to contribute to a traditional IRA. If you earn income through a business that you own, a side hustle, or through self-employment, you could open a SEP IRA.

How to open a SEP IRA

You can open a SEP IRA with most banks and brokerages that offer IRAs.

  1. Choose your account provider.
  2. Create a formal written agreement. Your account provider may provide this for you, or you could use IRS Form 5305-SEP.
  3. Give all eligible employees information about their SEP IRAs. You could either give them a copy of the IRS Form 5305-SEP or give them any documents provided by your plan provider.
  4. Set up SEP IRAs for each eligible employee.

SEP IRAs are much simpler and cheaper to open and administer than a traditional employer-sponsored plan like a 401k.

Also read: Retirement Plan Options For Business Owners

Benefits of a SEP IRA

  • A SEP IRA is easy to set up and administer.
  • It's a cheaper, easier option of offering a retirement plan for your employees, compared to traditional employer-sponsored plans like the 401k.
  • Contributions are tax deductible.
  • Earnings in your account are tax-deferred until retirement.
  • The contribution limits are over 10x higher than a traditional IRA.
  • You don't need to contribute each year, and you could change how much you contribute every year.
  • For employees, contributions made by your employer are immediately 100% vested. While you cannot make contributions as an employee, you still own and direct your account.

Disadvantages of a SEP IRA

  • There is no Roth option with a SEP IRA.
  • There are no catch-up contributions.
  • You must make equal percentage contributions to every eligible employee's accounts.

Can I have a SEP IRA and a traditional IRA?

Yes, you are allowed to have both a SEP IRA and a traditional IRA. If you're an employer, your SEP IRA contributions do not affect your traditional IRA contributions. You can max out a SEP IRA and a traditional IRA separately. If you're an employee, your contribution limits are also not affected by your employer's SEP IRA contributions to your account. However, your tax deductions for a traditional IRA could get reduced if your income is too high.

Can I have a SEP IRA and a Roth IRA?

Yes, you are allowed to have both a SEP IRA and a Roth IRA. Since a SEP IRA does not have a Roth option, this is a popular choice for SEP IRA holders to make Roth deferrals. Like with the traditional IRA, contributions to a SEP IRA do not affect the contribution limits of a Roth IRA. However, you may not be able to contribute to a Roth IRA if your income is too high.

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