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What is a SEP IRA?

What is a SEP IRA?
Catherine Hiles
Updated October 12, 2021
7 Min Read

A Simplified Employee Pension IRA, or SEP IRA, is a retirement savings option for self-employed individuals or small-business owners. It allows the employer to contribute a certain percentage of their own and their employees’ earnings in an IRA that can be used to maintain a steady income after retirement.

How does a SEP IRA work?

A SEP IRA is a benefit provided by some employers to their employees. The employer contributes a certain amount of the employee’s earnings each year, and the contributions are invested in the same way they would be in a traditional or Roth IRA.

Unlike other types of IRA, the employee cannot also contribute to the SEP IRA. All contributions to this type of retirement savings account must come from the employer. The employee also cannot determine how much their employer contributes; that is the decision of the employer.

A SEP IRA is similar to a traditional IRA in that the contributions are made pre-tax. That means that when it comes time to withdraw money from the SEP IRA, you will have to pay taxes based on the tax rate at your retirement time.

Although you cannot contribute to a SEP IRA as an employee, the account belongs to you and you may keep the contributions within even if you are no longer an employee. There is no vesting period; 100% of the contributions are yours once they are made. You own and control the account and the contributions within.

SEP IRA contribution limits

Like other types of retirement funds, SEP IRAs have contribution limits that are set each year by the Internal Revenue Service. The current contribution limits are as follows.

  • Annual limit of $58,000 in 2021 ($57,000 in 2020) or 25% of earnings, whichever is smaller.
  • Contributions are based only on the first $290,000 of compensation in 2021 ($285,000 in 2020).
  • Employers must contribute the same percentage for every employee who has a SEP IRA, including themselves. Therefore, if the employer wants to contribute the full 25% for themself, they need to also contribute 25% for each employee.

These limits are much higher than the limits on other types of IRA, which are $6,000 in both 2020 and 2021. And while individuals 50 and older may contribute an extra $1,000 over that limit in 2020 and 2021, there is no such exception for older employees who have a SEP IRA.

Who qualifies for a SEP IRA?

Anyone who owns a business can qualify for a SEP IRA, but larger business owners may choose an alternative option for themselves and their employees. That’s because of the rule that the employer must contribute an equal percentage of each employee’s compensation as they contribute for themselves. Usually, people who choose SEP IRAs for their retirement savings are either self-employed or only have a couple of employees.

There’s also a rule on what constitutes an eligible employee when it comes to SEP IRA contributions. According to the IRA, an eligible employee must meet the following criteria in order to have an employer-provided SEP IRA.

  • Must be at least 21 years of age.
  • Must have worked for the employer for at least 3 of the last 5 years.
  • Must have earned at least $650 in compensation for 2021, and $600 for 2020 and 2019.

If you have employees who do not meet these criteria, you won’t be required to open a SEP IRA account on their behalf when you open one for yourself and any eligible employees.

Is a SEP IRA different from a traditional IRA?

Although the goals of a SEP IRA and a traditional IRA are similar, they have several important differences that distinguish them from one another.

  • With a traditional IRA, you can contribute your own money, and your employer may also contribute a certain percentage. A SEP IRA only allows contributions from the employer.
  • Traditional and Roth IRAs allow people over 50 years of age to contribute more than the limit as they near retirement age. There is no such exception with a SEP IRA.
  • With a regular IRA, you can choose whether your contributions are pre-tax (traditional) or after tax (Roth), but with a SEP IRA you can only contribute pre-tax. That means you will have to pay taxes on your money upon withdrawal.

Pros and cons of a SEP IRA?

Like any type of investment or retirement account, there are several pluses and minuses associated with a SEP IRA.

Pros

  • The contribution limits for a SEP IRA are higher than the contribution limits for a traditional or Roth IRA.
  • You can have a SEP IRA alongside a traditional or Roth IRA and max out the contribution limits for each without having to split the contributions between accounts.
  • Your SEP IRA contributions are tax-deductible, which means your taxable income will decrease and you will owe less money to the IRS each year.
  • You don’t have to contribute to a SEP IRA every year, so if your business has good years and bad years you can decrease contributions (or stop them altogether) during downturns in business.

Cons

  • You can’t choose a Roth option for a SEP IRA, which means you’ll be paying taxes on the money when you retire and withdraw the funds rather than when you make the contributions, which could mean you end up paying more in tax.
  • As the employer, you are required to contribute the same percentage for each employee that you contribute for yourself.
  • You must take minimum distributions starting at age 72.
  • If you withdraw money before the age of 59 ½, you will be required to pay a 10% penalty.

How to open a SEP IRA

If you are self-employed or a small business owner with a small number of employees, you can open a SEP IRA easily online through any IRA provider.

Once you have selected a provider, you must create a written agreement either using IRS form 5305-SEP or through your SEP IRA provider. You must then communicate the details of the SEP IRA to your employees and set each of them up with their own account through your provider.

How to invest in a SEP IRA

While only the employer can contribute to a SEP IRA, the account owner is in charge of determining how the contributions should be invested.

Like with other retirement investment accounts, you will likely base your investment strategy on your age. Younger investors can take larger risks by investing in stocks, which are more volatile but can pay off in the long term. Those who are closer to retirement age will generally go for the less risky option of investing in bonds, which are more predictable but often yield fewer returns. But the closer you are to retirement, the fewer risks you should take with your retirement savings fund.

To decide which specific stocks and bonds to invest in, you’ll need to check with the SEP IRA provider to see what investment opportunities they offer. If your SEP IRA is through a bank, you may be limited to investing in Certificates of Deposit, which yield lower returns than other forms of investment.

FAQ (Frequently asked questions)

Understanding the intricacies of a SEP IRA can take time. The following questions are designed to aid your understanding of this unique type of retirement savings account.

How much can I put in a SEP IRA?

The contribution limits for a SEP IRA are set each year by the IRS. For 2021, the limit is $58,000 ($57,000 in 2020) or 25% of compensation; whichever is smaller. The stipulation is that only the employer can contribute to the SEP IRA, so if you are the employee you don’t have control over how much is contributed each year.

A SEP IRA is very flexible, and the employer isn’t required to contribute the same amount each year. For a small business, that means in successful years you can contribute a larger amount for yourself and your employees, and then decrease that amount if your business hits a rough patch. For the employee, though, this means it’s not a very reliable way to save for retirement alone.

Can an employee contribute to a SEP IRA?

No; the only person who can contribute to a SEP IRA is the employer. If you are self-employed, you can also open a SEP IRA and contribute up to the IRS limit each year without being required to open additional accounts for employees.

Can I convert a SEP IRA to a Roth IRA?

Just like a traditional IRA, you can convert a SEP IRA into a Roth IRA. You will need to pay taxes on the balance in the tax year you make the conversion, though, and depending on your balance when you make the conversion that could be quite a hefty sum.

However, if you have the means to pay the taxes for an IRA conversion, it can benefit you in the long run because you won’t need to pay taxes on your contributions and earnings when you withdraw them after you retire. Chances are you’ll be in a higher tax bracket when you retire than you are now, so paying the taxes in your current tax bracket could save you money in the long run.

Can I have more than one SEP IRA?

You can have two or more SEP IRA accounts, but you cannot exceed the total contribution limit across the accounts. So, for 2021, your total contributions can’t exceed $58,000 or 25% of your income.

Can you contribute to a SEP and a Roth IRA?

You are not limited to contributing to one type of IRA. If you have a SEP IRA for yourself or through an employer, you can open a Roth IRA on your own and also contribute to that. Because the contribution limits are different (and not related) for SEP and Roth IRAs, you can contribute up to the limit for both rather than having to stick to a combined limit across accounts.

Summary

A SEP IRA is a good option for a self-employed individual or a small-business owner with few employees. Its high contribution limit means that you can build a hefty retirement nest egg, and its flexible terms mean you can pause contributions if your business goes through a downturn. But if your business has a lot of employees, you may choose to look for other options as you are required to match the contribution percentage for each employee that you contribute for yourself.

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