What is a SEP IRA?

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It’s a Simplified Employee Pension Individual Retirement Account. Super clear, right?

(We’re kidding.) A SEP IRA is a retirement account that offers tax advantages for business owners and those that are self-employed. And with “simplified” in the name, SEP IRAs are actually straightforward. They work much like Traditional IRAs where the money you contribute grows tax-deferred until retirement. Contributions are also tax deductible, up to a certain amount.  

How does a SEP IRA work?

SEPs can be attractive options for small business owners because they can be easy to set up and maintain. It’s up to the business owner to set up the SEP and decide when and how much they’ll contribute for their employees. However, employees own and control their accounts, including any investment decisions.  

Who can open a SEP IRA?

While technically any employer can open a SEP,  they are generally recommended for business owners with few or no employees. The reason? If you’re a business owner offering a SEP IRA, you contribute on behalf of your employees, and the IRS requires that you contribute equally to all accounts. So for instance, if you want to contribute 20% of your own salary toward a SEP, you also have to contribute 20% of each eligible employee’s salary.  

What are the SEP IRA eligibility requirements for employees?

If you’re a small business owner, you must include employees in the SEP plan if they:

  • Are 21 years or older.
  • Have worked for the business in at least 3 of the last 5 years.
  • Receive at least $600 in compensation annually.

You may also choose less restrictive requirements for your plan (e.g., 18 years or older, three months of service).

How to set up a SEP IRA?

The first step is to choose an account provider for your SEP IRA. There are a number of financial institutions to choose from, so do some research to find one that works for you. Once you’ve chosen where to open your account, the IRS requires the following: 

  • Create a written agreement for all eligible employees. The IRS provides a model plan document (Form 5305-SEP) as a template. Your account provider may also have a template. 
  • Give employees information about the SEP IRA. (This may seem obvious, but yes, you have to tell your employees about their retirement plan options). 
  • Set up an IRA account for each employee.

These are the basic steps, but the IRS website lists the information required to inform your employees, along with more detailed requirements. 

How much can you contribute to a SEP IRA?

This is where the SEP IRA shines in comparison to a Traditional or Roth IRA, which only allow you to contribute up to $6,000 in 2019. With a SEP IRA, employers can contribute up to $56,000 or 25% of an employee’s compensation, whichever is less. Just remember that business owners have to contribute equal percentages to each employee’s account. 

SEPs can be attractive options for small business owners because they can be easy to set up and maintain

The one drawback is that SEP IRAs do not allow “catch-up” contributions. Typically, catch-up contributions allow you to contribute more money once you turn 50 (an additional $1,000 for Roth and Traditional IRAs in 2019) since you’re likely closer to retirement. 

Can I contribute to a Traditional or Roth IRA in addition to a SEP?

Generally, yes. This can get a little confusing though because a SEP IRA is technically just an individual retirement account that holds contributions under a SEP plan.

Here’s the deal: Even though your employer must contribute to your SEP IRA, you may also be able to contribute. Alternatively, you could open up a separate Roth or Traditional IRA and contribute your own money that way. Just keep in mind that whatever individual contributions you make cannot exceed the total contribution limit for IRAs ($6,000 in 2019). 

Still confused? So were we when looking up the IRS rules. Let’s look at an example.

Say Sophia is the owner and sole employee of Company A, which offers a SEP IRA. Under that plan, Company A regularly contributes to Sophia’s SEP IRA – they even contribute the $56,000 maximum allowed for 2019. Remember, this is really all just Sophia’s money since it’s her company, but it’s an important distinction that it’s the business making the contributions.

Sophia also decides to contribute $3,000 to her SEP IRA this year. On top of that, she opens a Roth IRA. At this point, Sophia can only contribute $3,000 to her Roth IRA, bringing her total individual contributions up to the $6,000 maximum. 

(And go Sophia for being a savvy business owner and maximizing her retirement savings!) 

What other SEP IRA rules do I need to know about?

Here are some other things to keep in mind if you’re considering a SEP IRA:

  • Employer contributions vest immediately, which means the contributions don’t have to be earned based on an employee’s tenure. It’s a great benefit for the employee, but a potential downside for the employer, who may want to use vesting as a way to keep people from leaving too soon.  
  • If you’re participating in a SEP plan and withdraw your money prior to age 59½ you’re generally subject to income tax and a 10% penalty. After age 59½ you’ll be subject to income tax but no penalty. 
  • You must take requirement minimum distributions (RMDs) in the year you turn 70 ½.

How do I know if a SEP IRA is right for me?

Given the high contribution limits, a SEP IRA may be a great option if you’re a one-person shop. SEP IRAs are easy to set up and administer, which is probably music to your ears if you run your own business. They also have low administrative costs and allow you to contribute on your own terms each year.  

If you’re not sure that a SEP is right for you, there are other retirement plans available for individuals and small business owners. 

Reaching your goal starts with saving for it.

This article is for informational purposes only and is not a substitute for individualized professional advice. Articles on this site were commissioned and approved by Marcus by Goldman Sachs®, but may not reflect the institutional opinions of The Goldman Sachs Group, Inc., Goldman Sachs Bank USA or any of their affiliates, subsidiaries or divisions.