Understanding the Operation of a SEP IRA
A SEP IRA, short for Simplified Employee Pension IRA, is a retirement savings plan that both self-employed individuals and small business owners can utilize to save funds for their golden years in a tax-efficient manner. Similar to other IRAs, a SEP IRA is completely owned and managed by the account's beneficiary.
What is a SEP IRA?
What does a SEP IRA entail?
A SEP IRA serves as a retirement savings tool that allows small business proprietors along with their employees to put aside funds for the future. Like other IRAs, SEP IRAs are entirely owned and controlled by the account holder.
While SEP IRAs are available to businesses of all sizes, they are particularly beneficial for self-employed individuals and businesses with only a few employees. Employers that establish a SEP IRA are responsible for making 100% of the contributions, and they must offer identical benefits to all eligible employees.
How does a SEP IRA function?
How does a SEP IRA work?
Employees themselves do not make contributions to a SEP IRA; instead, the company owner contributes the entire amount to their respective employee accounts. For each SEP IRA, the contribution percentage must be equal between the owners and employees. If the employer contributes 25% of their annual income to their SEP IRA, they are required to contribute this same percentage for each employee, equating to at least 25% of the employee's salary.
The funds within a SEP IRA are controlled by the individual employee, and these investments grow on a tax-deferred basis until the owner withdraws from the account. With the introduction of the Secure Act 2.0, SEP IRAs now offer the option to make Roth (post-tax) contributions, which can be withdrawn tax-free during retirement.
Once individuals reach retirement age and withdraw from their SEP IRA, they are liable to pay taxes on these withdrawals, just like with a traditional IRA. Early withdrawals, before the age of 59 1/2, are subject to a 10% penalty. SEP IRA holders must also take annual minimum distributions starting at age 73.
Learn more about Understanding SEP IRA regulations
Investment options for SEP IRAs
Available investment options for SEP IRAs
SEP IRA owners have minimal restrictions when it comes to the types of assets they can invest in. For instance, collectibles and life insurance are not permitted by the IRS for SEP IRAs. Additionally, trading derivatives with undefined or unlimited risk is prohibited.
The investment options available to SEP IRA holders vary depending on the brokerage where the account is maintained. Generally speaking, SEP IRA owners can purchase and sell stocks, bonds, exchange-traded funds (ETFs), mutual funds, money market funds, and certificates of deposit (CDs) through most brokerages. Some brokerages may restrict certain types of trading activities such as options trading.
Who is eligible for a SEP IRA?
Who qualifies for a SEP IRA?
You become eligible for a SEP IRA if you are either self-employed or a business owner. If you have employees, they are considered eligible by the IRS if they meet the following criteria:
- At least 21 years old
- Have worked for the company for at least three out of the past five years
- Earn at least $750 in compensation in 2024 and 2025
All eligible employees must have SEP IRAs established for them. While an employer may set less stringent eligibility requirements, these guidelines must be applied equally to all the company's owners and employees. A business owner can change the eligibility criteria at any time, provided that the new criteria is at least as rigid as the IRS criteria.
SEP IRA contribution limits
Contribution limits for SEP IRAs
The maximum annual contribution limit for a SEP IRA is the lesser of:
- 25% of the business owner or employee's compensation
- $69,000 in 2024, or $70,000 in 2025
This contribution limit is significantly higher than the $7,000 standard contribution limit for an IRA in 2024 and 2025. Employers have the option of not funding a SEP IRA in a given year if they choose to treat all owners and employees equally.
Combining a SEP IRA with other retirement accounts
Mixing SEP IRAs with other retirement plans
If you have a SEP IRA, you can establish additional retirement accounts. However, the IRS may impose some additional restrictions on your contribution capacity due to SEP IRAs being an employer-sponsored retirement plan.
Combining a SEP IRA with a traditional IRA
If you participate in a SEP IRA, you can still open a traditional IRA. However, if your employer contributes to your SEP IRA and your annual income exceeds a certain amount, your contributions to a traditional IRA may not be fully tax-deductible.
For 2024, the tax deduction phase-out begins when your modified adjusted gross income reaches $77,000 for individual taxpayers and $123,000 for couples filing jointly. In 2025, these thresholds increase to $79,000 for single filers and $126,000 for married couples filing jointly.
Combinating a SEP IRA with a Roth IRA
You can establish a Roth IRA even if you participate in a SEP IRA. The maximum annual contribution limit for a Roth IRA remains unaffected, no matter if you have an employer-sponsored retirement plan such as a SEP IRA.
Combining a SEP IRA with a 401(k)
You can have a SEP IRA and a 401(k), but you will encounter certain restrictions when making contributions to a 401(k) based on your participation in a SEP IRA. These limitations are subject to the IRS guidelines for combining retirement accounts.
It's improbable to have a SIMPLE IRA and a 401(k) from the same workplace due to the annual contribution limitations for employers, which apply to both sorts of accounts collectively. If you have two distinct jobs offering two retirement plans, you can participate fully in both employer-sponsored retirement plans. You can have a SIMPLE IRA at one job and a 401(k) at the other.
SIMPLE IRAs and Health Savings Accounts (HSAs)
You can contribute to both a SIMPLE IRA and an HSA. SIMPLE IRA contributions do not affect HSA contribution limits or the tax treatment of HSA contributions. If your employer offers both a SIMPLE IRA and an HSA and contributes matching funds to the HSA, those HSA funds are not considered income to you as an employee.
How to Establish a SIMPLE IRA
Establishing a SIMPLE IRA is a straightforward process. Most banks and brokerages provide a pre-approved SIMPLE IRA plan prototype that meets IRS standards. The IRS also offers business owners the option of using its own model SIMPLE or a custom plan.
Employers must provide all relevant information about the SIMPLE IRA to employees. Then the business owner can open individual accounts for each eligible person.
The annual deadline to open and fund a SIMPLE IRA is the due date of the company's income tax return. The deadline to open and fund an account for 2024 is when the business files taxes in 2025.
Is a SIMPLE IRA Right for You?
SIMPLE IRA contributions are deductible as a business expense on corporate tax returns, and, for self-employed individuals, SIMPLE IRA contributions are tax-deductible on individual tax returns. These tax benefits, combined with the low cost and administrative simplicity of establishing a SIMPLE IRA, make them appealing to many entrepreneurs.
However, since business owners are responsible for 100% of contributions to SIMPLE IRAs and must contribute equally on a percentage basis to the SIMPLE IRA of every owner and employee, SIMPLE IRAs are not suitable for every business. SIMPLE IRAs are best designed for small businesses with few employees and with few or none of those employees meeting the eligibility requirement. Highly compensated owners of single-person businesses can also benefit from SIMPLE IRAs because of the high contribution limits.
If you earn enough money to contribute the maximum permissible amount to a SIMPLE IRA, a SIMPLE IRA may be a smart choice. But if you are self-employed with no employees, then a Solo 401(k) may be a better option.
Related Retirement Topics
Individual Retirement Accounts (IRAs)
Under the umbrella of individual retirement accounts, there are many options.
401(k)
Learn how these employer-sponsored retirement plans work and if they’re right for you.
Retirement Plans
Learn how, why, and how much to save for your golden years.
Retirement Strategies
You know you need to save for retirement. Here are some strategies.
Our Website has a disclosure policy.
To maximize savings for retirement, a self-employed individual could consider contributing to both a SEP IRA and a personal savings account, setting aside additional funds beyond the SEP IRA's annual contribution limit.
In planning for their golden years, individuals with a SEP IRA should also explore the investment options available in traditional retirement accounts, such as IRAs or 401(k)s, to diversify their retirement portfolio and potentially benefit from additional tax advantages.
