In this article, we’ll cover…

  • Define a SEP IRA

  • Explain who can use a SEP IRA

  • Outline how much one can contribute to a SEP IRA

  • Benefits and drawbacks of a SEP IRA

  • How to implement a SEP IRA

What is a SEP-IRA?

A SEP-IRA plan allows employers to set money aside in retirement accounts for themselves and their employees. These plans do not have the start-up costs and operating costs of conventional retirement plans and allow for a contribution of up to 25% of each employee’s pay.

Who can use a SEP-IRA?

Qualifications for a business include

  • Must be a sole proprietor, partnership, or corporation

Qualifications for individuals include:

  • Age 21 or older (there are age exceptions, contact the IRS for more info)

  • Worked for the business for at least 3 of the last 5 years

  • Received compensation of at least $650 in 2021 and 2022 and $600 in compensation per year from 2016-2020

  • Not covered under a collective bargaining agreement

Contributions

For Employer 

  • Can contribute up to 25% of the employee’s total compensation or a maximum of $61,000 for the 2022 tax year

  • For the self-employed, contributions are limited to 20% of net income (determine by net profit from IRS Scheduled C reduced by the deductible self-employment tax) and capped at $305,000 for 2022

  • Contributions are deductible and it is not necessary to contribute every year, only employers can contribute, not employees

  • Contributions must be the same percentage of pay for all qualified employees

  • Contributions must be made by the due date for federal income tax in the year contributed.

  • Employees will typically not make contributions

  • Employees cannot defer their salary in order to make contributions to a SEP-IRA

  • There may be the ability to make traditional IRA contributions to the SEP-IRA of up to $6,000 ($7,000 for employees age 50 and older) for the tax year 2022

    • This amount limit includes other IRAs as well, meaning if you have a Roth IRA and an SEP-IRA, you cannot contribute more than $6,000 to both as an individual under 50 years old

  • Contributions to the SEP are always 100% vested (or owned) by the employee

What if I have a 401K with another employer?

  • If you participate in another employee-sponsored retirement, your total annual employee contributions to all plans cannot exceed 25% of your net earnings up to $61,000 in 2022 (the limit is whichever is smaller)

How are SEPs Taxed?

Employer

  • Typically, 100% of all contributions are tax-deductible to the business

  • Contributions over the limits listed above would be subject to taxes

Employee

  • Contributions made to the account on behalf of an employee are with pre-tax earnings

  • All investment growth occurs tax-free

  • SEP-IRA holders are able to withdraw funds without incurring a penalty once reaching age 59 ½

    • The penalty for premature withdrawals is 10%

  • SEP IRA accounts are subject to a Required Minimum Distribution in the year the account owner turns 72

Cons of SEP-IRA

For Employer

  • Contributions are immediately vested, meaning the contributions belong to the employee as soon as they are made (this is a positive for the employee)

For Employee

  • Contributions cannot be withdrawn at any time without applicable taxes before age 59 ½.

  • Participant loans are not allowed

How do you set up a SEP-IRA?

Setting up a SEP-IRA is a relatively straightforward process. First, you must find a financial institution to serve as the trustee of the SEP-IRAs. Institutions include Charles Schwab, TD Ameritrade, Vanguard, Fidelity, E-Trade

  • These are the next steps from the IRS:

  1. “Execute a written agreement to provide benefits to all eligible employees.”

    1. Must include the name of employer

    2. Requirements for employee participation

    3. Signature of a responsible company official and definite allocation formula

      This sounds complicated, but can be completed using IRS Form 5305-SEP. You are not required to submit the form to the IRS.

  2. “Give employees certain information about the agreement.”

    1. You must inform your employees

      1. That you have adopted SEP

      2. The requirement necessary for receiving an allocation

      3. How the employer will contribute to the SEP-IRA

    2. The employer must give a copy of the 5305-SEP form to all employees (eligible or not)

  3. “Set up a SEP IRA account for each employee.”

    1. The SEP IRA must be created for each eligible employee

    2. All contributions to the SEP go to traditional IRA

    3. Employees must make decisions about the investment of their SEP funds