SEP IRAs: How do they work & are they worth it?

Simplified employee pension (SEP) IRAs allow self-employed people and small businesses to save as much as $56,000 annually for retirement.

Derek Silva

Derek Silva

Published November 12, 2019

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KEY TAKEAWAYS

  • Only employers can contribute, with a contribution limit of $56,000 in 2019

  • All employees must receive proportional contributions

  • Contributions are tax-deductible for employers and sole proprietors

  • Tax reporting is greatly simplified compared to other accounts, like 401(k) plans

A simplified employee pension (SEP) IRA is a type of retirement account available to small businesses and self-employed individuals. You can open one if you are a sole proprietor, partnership, limited liability corporation (LLC), C corporation, or S corporation. You can also continue to offer a SEP IRA if you open it while you are the only employee and then you hire other employees.

For self-employed people, SEP IRAs work similarly to a traditional IRA in many ways. You can make pre-tax contributions, which you put into investments of your choice, and then you don’t pay income tax until you withdraw the money from the account. Though if you are an employee, your employer makes the contributions and they don’t come out of your salary. Like other IRAs, SEP IRAs have a contribution limit: $56,000 for 2019 and $57,000 for 2020.

You cannot make a withdrawal, officially known as a distribution, until you reach age 59 1/2. If you withdraw money before that age, you will pay income tax on it and a 10% penalty on the amount of your distribution. Once you reach age 70 1/2, you have to begin taking required minimum distributions (RMDs).

However, there are some specific rules about how to make contributions. Namely, every eligible employee has to receive a proportional contribution. So if you establish a SEP IRA and then contribute 15% of your salary into the plan, you also have to make a 15% contribution for each of your eligible employees.

In this article:

Who is eligible for a SEP IRA

As mentioned, a SEP IRA is an option for self-employed individuals and small companies. If a company has established one, then all eligible employees can receive contributions.

The Internal Revenue Service (IRS) defines an eligible employee as someone who meets three conditions:

  • They are at least 21 years old.
  • They have done work for the employer in at least three of the last five years.
  • They earned at least $600 for their work in that time.

If they’d like, employers can use more lax requirements. For example, an individual employer can decide to include employees who have worked for them in just two of the past five years. However, employers cannot use a more strict criteria than what’s mentioned above.

Employers define their eligibility requirements in a SEP IRA’s plan document, which lays out the details of the plan. We’ll talk about that document more when we talk about how to establish a SEP IRA.

Contribution limits for a SEP IRA

The 2020 SEP IRA contribution limit is $57,000 or 25% of your pay, whichever is smaller. The limit increases regularly to keep up with inflation and was $56,000 for 2019. Unlike other retirement accounts, SEP IRAs do not allow catch-up contributions.

And while a SEP IRA is a type of IRA, it’s important to note that your contribution limit applies to your total contributions to a SEP IRA and any defined contribution plans, such as a 401(k). So if you also contribute to a 401(k), 403(b), profit-sharing plan, or a money purchase plan, the total you can contribute across all those accounts is $56,000 for the year, and will be $57,000 in 2020.

Conversely, contributions to a SEP IRA do not count against your annual IRA contribution limit ($6,000 for 2019 and 2020). That means you could potentially make a maximum contribution to a SEP IRA and then to a separate Roth IRA if you wanted.

Advantages of a SEP IRA

You may want to consider a SEP IRA because they are easy to create and maintain. Administrative costs are low and aside from sole proprietors, you don’t have to do much — if any — reporting to the IRS. For example, contributions are not included on an employee’s W-2 form the way 401(k) contributions are.

There is also a lot of flexibility with how much and when you can contribute. For one, it isn’t necessary to make the same contribution each year. If your business struggles one year, you can contribute less. And if you don’t want to make any contribution one year, that’s also possible. This flexibility allows you to contribute more when you have the money and less when you don’t.

If you’re a sole proprietor or an employer, SEP IRA contributions are also tax-deductible. That means you can reduce your taxable income while contributing to your employees’ retirement accounts. Investments also grow tax free. Employees cannot take a tax deduction on their returns since they are not making the contributions themselves.

SEP IRAs are also popular for sole proprietors because they offer higher contribution limits than other IRAs. The time and money required to open and maintain a plan are also relatively low.

Another big advantage is that you have until the company’s tax filing deadline to make employee contributions. So if your company’s tax return is due in April and you file a six-month tax extension, making your tax return due in October, then you have until the October tax deadline to make employee contributions. This same deadline also applies to creating a SEP IRA for the previous tax year.

Potential drawbacks of a SEP IRA

The major reason you may not want a SEP IRA is that if you establish and contribute to one, you have to contribute a proportional amount for all of your eligible employees. Remember that all of the contributions to your employees’ SEP IRAs come from you, their employer. This may not be a big deal when you only have a couple of employees, but it becomes more challenging as team size increases.

Because the employer makes all contributions, an individual employee cannot contribute more if they want to save more for their own retirement. Instead, they will need to open an IRA or another type of savings account.

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How to establish a SEP IRA

You can open a SEP IRA with a few general steps.

  1. Choose a plan administrator
  2. Choose and sign a plan document
  3. Provide employees with a copy of the plan document

Step 1: Choose a plan administrator for your SEP IRA plan

The plan administrator, or trustee, of your plan is either a retirement plan professional or a financial institution that was approved by the IRS to manage retirement accounts. Common trustees are banks, mutual funds, and insurance companies that issue annuities.

Choosing the right trustee is important because they will manage collecting contributions, making the proper investments, providing annual statements, and making the required filings with the IRS.

As you look for a trustee, consider what kind of investments they allow. The most common investment options are mutual funds and exchange-traded funds (ETFs). While you don’t need to choose the institution with the most options, you ideally want a variety of low-cost options.

Step 2: Create and sign a plan document

Your plan document is a legal document that outlines the details of your SEP IRA. It includes the name of the employer, the requirements an employee must meet to become a plan participant, and details on calculating contributions. As mentioned above, there are contribution limits but an employer can choose more lax requirements if they want. The document is not complete until it has been signed by the employer.

To help you get started, the IRS offers a sample plan document that you can use: Form 5305-SEP, Simplified Employee Pension – Individual Retirement Accounts Contribution Agreement. You just need to update the information on contributions limits, which you can find on the IRS website, because the IRS hasn’t updated the numbers on this form since 2004.

Any plan trustee you choose can also help you create a proper document and they will have sample forms you can use.

You do not need to provide a copy of your trust document to the IRS. Even if you use the model form from the IRS, your plan document is only for your records. You, your plan administrator, and your employees are the only ones who need to receive copies.

Step 3: Provide employees with a copy of the plan document

Once you have created a plan document, you need to distribute it to all employees. Additionally, you need to provide a written statement that explains three main pieces of information:

  • A SEP IRA may provide different rates of return and contain different terms than other IRAs the employee may have.
  • The plan’s administrator will provide a copy of any amendments within 30 days of the effective date. They will also provide an explanation of the amendments’ effects.
  • By January 31 of the following year, all plan participants will receive a written report of the employer’s contributions to their SEP IRAs.

According to the IRS, your plan is not officially adopted until each employee has received a written copy of this statement.

Tax forms you file for a SEP IRA

There are not many tax filing requirements with a SEP IRA. As mentioned, you do not need to send a copy of your plan document to the IRS. You also do not need to include contributions on employee W-2 forms. The few types of necessary tax reporting are all handled by your plan’s trustee.

The financial institution or trustee managing your plan needs to provide the IRS and all participating employees with an annual statement of the employer’s contributions and any required minimum distributions (RMDs). RMDs are withdrawals that individuals must make once they reach age 70.5.

Contribution information is presented on IRS Form 5498, IRA Contribution Information. If there are any RMDS, they will be on this form and on Form 1099-R. Any employee who makes a distribution will also receive a 1099-R. The IRS must also receive a copy of both forms.

Terminating a SEP IRA

It is possible to terminate a SEP IRA. In some cases, like when your company reaches a certain size, it may also make sense to transition to another type of retirement account. Simply talk to your plan administrator and they will help you through the process. If you have questions about the best type of plan for you and your company, you may want to speak with a tax professional or financial advisor.

You do not need to notify the IRS when you terminate a SEP IRA. In fact, it isn’t even mandatory to notify your employees (though we highly recommend you tell them).

Alternatives to a SEP IRA

Even with the flexibility and tax advantages, a SEP IRA is not always the best choice for an employer. There are a number of other retirement accounts available for small business owners. IRS Publication 3998 will give you a brief overview of the plans available to you.

If you want to allow additional employee contributions, a SIMPLE IRA is one popular option for companies with fewer than 100 employees. They are also inexpensive to maintain but have a much lower contribution limit of $13,000 for 2019 and $13,500 for 2020. (Catch-up contributions of $3,000 are available with a SIMPLE IRA once a participant reaches age 50.)

Before 1997 there was an additional kind of SEP IRA account known as a SARSEP, and it included a salary reduction arrangement. This was a type of salary deferral that let employees elect for some of their salary to be contributed into the account. Salary reduction arrangements are no longer available with a SEP IRA.

Employers that are looking to make very large contributions may want to consider profit-sharing plans and safe harbor 401(k) plans. A solo 401(k) is also an option for sole proprietors and for employers who have no full-time employees other than themselves and their spouses.

You should talk with a professional for more detailed tax advice and you should also check with the IRS for the most recent details on contribution limits and reporting requirements.

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