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May 11, 2023
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Given the events of the past several years, it’s no surprise that many people across the globe are finding alternative ways to earn an income. Whether you’ve changed jobs to a smaller employer or started working for yourself, it’s possible that a traditional 401(k) or 403(b) is no longer on the menu.
Introducing the SEP-IRA, or the Simplified Employee Pension – Individual Retirement Account. The SEP-IRA is an employer-sponsored retirement account aimed at providing small employers and self-employed individuals a way to save for retirement. The SEP-IRA comes with a variety of eligibility rules and contribution limits, so it’s smart to learn where you stand when it comes to your ability to participate.
The SEP-IRA is intended for small employers and the self-employed (including small business owners and freelance workers) to act as their own plan administrators. You’re not going to find SEP-IRA enrollment forms at large corporations, educational institutions, or government workplaces — in these environments, you’re more likely to fund retirement savings through 401(k) plans, 403(b) plans, and 457 plans, respectively.
Generally speaking, SEP-IRA eligibility rules allow you to participate if you:
One thing to note: an employer can use less restrictive rules, but not more restrictive rules. So, make sure to double-check with your employer.
Assuming you meet the eligibility requirements, your employer has created a SEP-IRA plan, and your employer is prepared to make contributions, it’s time to start thinking about contribution limits.
A major takeaway here is that employers have a high contribution limit when it comes to depositing funds into their employees’ accounts. On the other hand, employees are limited to the same $6,500 limit imposed on all IRA contributions.
Put another way, employees can only contribute a maximum of $6,500 annually to all IRAs (or $7,500 if you’re 50 or older), and deposits to a SEP-IRA account are included against this limit.
It’s also important to know that if an employer wants to contribute a large percentage of their income to their SEP-IRA, they’ll have to contribute the same percentage (or more) to all employees’ SEP-IRAs.
For example, if a small business owner wants to contribute 20% of his income to a SEP-IRA, employees will get the same 20% contributed to their own respective accounts. This is a unique feature of SEP-IRAs and may result in a large percentage of compensation coming in the form of retirement contributions.
The simple answer is: Yes, SEP IRA contributions are tax-deductible. However, the specifics of SEP-IRA tax deductions depend on whether you are an employer or an employee.
For an employer (e.g. a self-employed business owner), the maximum deduction an employer can take for any given year is the lesser of their contributions or 25% of total compensation. So, for example, if an employer earned $100,000 in net income for the year, they would be able to contribute a maximum of $25,000 to their SEP-IRA and take a tax deduction for the same amount.
For employees, the deduction is limited to $6,000 — same as for a standard IRA contribution — and is subject to standard IRA contribution requirements.
Yes, contributions to SEP-IRAs are considered “pre-tax.” Funds grow in the account tax-deferred, and, upon withdrawal, you pay taxes on the full amount you take out. This is similar to a pre-tax 401(k) or a traditional IRA funded with deductible contributions. In these accounts, like in the SEP-IRA, invested money has yet to be taxed.
Unlike a Roth 401(k) or a Roth IRA, there is no post-tax version of a SEP-IRA where you can eventually make tax-free withdrawals. If you want to make post-tax contributions to a retirement account, you might consider funding your SEP-IRA through your employer and then saving any excess funds in a self-funded Roth IRA (if you earn less than the income limits).
You can expect the same withdrawal rules for SEP-IRAs as you would for traditional IRAs:
If you have a SEP-IRA from a former employer, yes, you can roll it over (ideally via direct rollover or “trustee-to-trustee transfer”) into another retirement savings account. This is a bit different than a 401(k) to IRA rollover, as this would be considered an IRA rollover. However, like all rollover IRAs, there are tax considerations depending on the type of account to which you’re transferring.
Here’s a quick summary:
| SEP-IRA rolling over to… | Traditional IRA | Roth IRA |
|---|---|---|
| Is a rollover possible? | Yes | Yes |
| Is the rollover taxable? | No | Yes |
While the above table illustrates two common scenarios many investors might encounter, there are many other potential rollover situations with varying tax consequences — as you can see on the IRS’ own rollover chart.
But, broadly speaking, you’re allowed to combine accounts without any tax penalty if the tax treatment of both accounts is the same (e.g. pre-tax to pre-tax, post-tax to post-tax); rollovers involving accounts with different tax treatments (i.e., pre-tax to post-tax) are possible but will result in additional tax liability.
While of course this is a question only you can answer, the SEP-IRA is most typically suited for small business owners with few employees and the self-employed — two groups that typically do not have access to an employer-sponsored retirement plan, like a 401(k) or 403(b) Note: 401(k)s and 403(b)s are sometimes called qualified plans, or QRPs.
If, on the other hand, you’re self-employed, freelancing, or simply have a side hustle apart from your day job, a SEP-IRA might work for you. You’ll be able to enjoy significantly higher contribution limits along with a tax deduction in the year of contribution.
If you’re a small business owner who can’t offer a 401(k) or 403 (b), that doesn’t necessarily mean you have to open a SEP-IRA for your employees. Another popular option for businesses with fewer than 100 employees is a SIMPLE IRA (Savings Incentive Match Plan for Employees IRA).
The major difference between a SEP-IRA and a SIMPLE IRA is that, with a SIMPLE IRA, employees elect to have their IRA contributions pulled automatically from their paychecks like income taxes. Employers match these contributions up to 3% of the employee’s annual salary.
If you’re a new employer and looking to become a retirement plan administrator, you may want to speak to a financial and/or tax advisor about choosing an IRA account that best fits your needs.
Most of the major brokerages offer SEP-IRA retirement plans that can be opened online (with some additional paperwork).
You’ll want to compare your options to make sure you find the right financial institution. Some common considerations include whether the investment choices are made for you or if you get to pick your own portfolio, the annual fees, and user interface. A lot of this comes down to personal preference, so make sure to do your research to find the best investment option for you.
A SEP-IRA is simply a way for small business owners and/or the self-employed to save for retirement. These accounts have higher contribution limits and more robust tax-deduction potential (for the employer) than do most traditional retirement plans.
Your personal tax situation, along with your overall financial picture, will help dictate if a SEP-IRA is the best option for you. Given that you have many choices when it comes to opening a SEP-IRA, take the time necessary to evaluate the consequences of each one.
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