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What Is a SEP IRA? Everything You Need to Know

Simplified employee pension (SEP) IRAs are retirement accounts that act very similar to traditional IRAs, but are meant for self-employed individuals and/or can be offered by your employer. SEP IRA plans can be a great alternative to traditional employer plans, such a 401(k), due to the much lower startup and maintenance costs.

SEP IRAs have much higher contribution limits than traditional and Roth 401(k) and IRAs – $57,000 compared to $6,000 – but there’s a catch, only the business owners can contribute into the plan for you. Let’s take a look into how they work.

How To Open a SEP IRA

SEP IRAs are either set up by your business, or yourself, if you are a self employed individual. When stacked up against the steps to create a 401(k) plan for a company, SEP IRAs are rather easy. 

The IRS does not discriminate what type of business can start a SEP plan – corporations, partnerships, and sole proprietorships all can set one up. Simply complete and submit the mandatory Form 5305-SEP and proof of employees to the IRS. 

To participate in your employers SEP IRA, you qualify, and meet all of the IRS’ requirements:

  • Must be at least 21
  • Employee has been with the company for minimally 3 of the last 5 years
  • Employee has been paid $600 or more by the company within the year

How Do SEP IRA Contributions Work?

Contributions are capped at whichever is lesser of the two: 25% of an employees compensation, or $57,000 (2020) – compare that to 401(k)’s $19,500 annual contribution limit. The kicker is that you do not choose the amount, the business owner does, but they do not on an individual basis. The percentage of an employee’s compensation being allocated toward the SEP plan stays consistent with all other employees, and the owner. 

Contributions are 100% vested, and the employee will be able to pick and choose how those are allocated. Similar to traditional IRAs, these funds grow tax-deferred until withdrawals begin at retirement or after age 59 ½. Early withdrawals do enjoy the 10% tax penalty, which is similar to other IRA plans.

SEP plans can be attractive to smaller businesses because they have the liberty to choose if they will or will not be contributing into their employee’s plans. Imagine you are a small internet startup with inconsistent revenues — the owner will have the choice to not contribute into the worker’s plans for that year, which is an eye opening downside of SEP IRAs.

If you are a business owner and contributes to your employees’ SEP plans, you can deduct those from your business’s taxable income.

SEP IRA vs. SIMPLE IRA

When picking a retirement plan for your small business, SEP and SIMPLE IRAs are cost effective, and provide both tax benefits to you and your employees. The major difference of the two are rules of who can contribute, and how much.

We’ve summarized and compared the highlights of SEP and SIMPLE IRAs below:

Retirement Plan:SEP IRA SIMPLE IRA
ContributorEmployer onlyEmployer or employee
Contribution LimitLesser of 25% of an employee’s salary or up to $57,000$13,500 (additional catch-up contribution of $3,000 if ages 50+)
Match IncentiveNot offeredRequired – dollar for dollar up to 3% of a the employee’s income, or 2% 

What’s Next: Understanding Your Retirement Plan

SEP IRAs are much different than other plans in the IRA family, and if you are still unsure how they fit into your portfolio, it’s okay to ask for help – that’s what financial advisors are here for. 

Never worked with a financial advisor? Don’t worry, Investment Firms has done the heavy lifting for you, and helps you meet with registered advisors in your area. Simply answer a few filtering questions and connect with an advisor as soon as today with our matching tool!