What Is a SEP IRA?

A Simplified Employee Pension (SEP) individual retirement account is an alternative to a traditional IRA that gives business owners a simplified way to contribute to their and their employees’ retirement savings. They can contribute up to $57,000 a year in 2020 to each person’s IRA or annuity.

Basics of SEP IRAs

A Simplified Employee Pension IRA is a retirement plan similar to a traditional IRA. They’re designed to provide tax advantages for small business owners and self-employed workers who want to save for retirement.

Each employee owns their own SEP IRA, meaning they have control over all the money in it.

If you have employees, you must contribute to plans on their behalf so long as they are eligible for SEP IRA participation.

SEP IRA Eligibility Rules for Employees
  • Must be 21 or older
  • Must have worked for the employer for three of the past five years
  • Must have earned $600 from your employer in the past year

The amount of money a business owner is required to contribute to employees’ SEP IRA has to be equal to the percentage of compensation the business owner contributes to his or her own SEP IRA.

So, if you are the business owner and contribute 15 percent of your compensation to your own SEP, you have to contribute 15 percent of each employee’s pay to his or her SEP IRA.

Employers can exclude some workers from participating in a SEP IRA, including nonresidents who don’t receive U.S. wages or other compensation, or union members covered by other retirement benefits.

How Does a SEP IRA Work?

SEP IRAs work much the same way as traditional IRAs when it comes to tax advantages. The money you contribute to your account is not treated as income for tax purposes. But you are also allowed to contribute more to a SEP than to a traditional IRA.

The same withdrawal and rollover rules apply to traditional and SEP IRAs.

If you participate in a SEP IRA, you choose where you want to invest your contributions from a list of options the account provider offers. Your investment options are free from the control of your employer.

If your SEP IRA is set up through a brokerage account, you can invest in stocks, bonds and mutual funds. But if it is set up through a bank you’ll be limited to certificates of deposit, which generally have a low rate of return.

Your retirement savings grows based on your continued contributions and the growth of your choice of investments.

Did You Know?
You cannot invest your IRA contributions into life insurance or collectibles, which include such things as artwork, antiques, stamps, coins and gold or most other types of bullion. If you invest your IRA funds in these items, you may have to pay a 10 percent penalty.

SEP IRA Contribution Limits and Early Withdrawals

You can contribute almost 10 times as much money to a SEP IRA as you can to a traditional IRA. In 2020, the maximum amount you can contribute to a SEP IRA is $57,000 per year, while the limit is $6,000 for a traditional IRA.

But unlike traditional IRAs in which participants can contribute an additional $1,000 contribution over the limit each year after they turn 50, SEP IRAs do not allow such “catch-up” contributions.

Your employer can also contribute to your SEP IRA — up to 25 percent of your annual compensation or $57,000, whichever is less.

What to Know About SEP IRA Withdrawals and Distributions

To withdraw money from your SEP IRA, you should contact the financial institution that administers the account rather than your employer. You will also need to complete and submit IRS Form 5329 to the Internal Revenue Service.

You can withdraw money from your SEP IRA at any time. You do not need to show a hardship to make a withdrawal.

But if you take money out of your SEP IRA before six months after your 59th birthday, you will have to pay a 10 percent penalty on top of paying income tax on the withdrawal.

Did You Know?
You have to make required minimum distributions (RMDs) each year starting six months after your 70th birthday (72 if the IRA owner died after Dec. 31, 2019). You calculate your RMD based on a formula using your age and life expectancy using IRS Publication 590-B.

Advantages and Disadvantages of a SEP IRA

One of the biggest advantages of a SEP IRA is that it allows self-employed individuals and their employees to receive tax advantages while saving for retirement. But there are also disadvantages when compared to a traditional IRA.

Advantages and Disadvantages of SEP IRAs
Advantages
  • A high, annual contribution limit — $57,000 in 2020.
  • All contributions, up to the legal limit, are tax deductible, including the ones an employer makes to employee SEP IRAs.
  • Can be combined with a separate traditional or Roth IRA.
  • So simple to set up and administer, the word “simple” is part of its name.
  • You don’t have to contribute every year to keep your SEP IRA.
Disadvantages
  • Does not allow “catch-up” contributions for people 50 and older.
  • Employers have to contribute the same percentage to employees he or she contributes to their own SEP IRA.
  • Must make required minimum distributions when you turn 72
  • There is no Roth IRA version of SEP IRAs, meaning you can’t plan on a tax-free retirement withdrawal.
  • With few exceptions, early withdrawals are subject to a 10 percent penalty in addition to income taxes.

Another disadvantage to a SEP IRA is that, even though you immediately own and control contributions in your retirement account, you will have to pay a 25 percent penalty on any money you withdraw from the account in the first two years it’s open.

Last Modified: October 9, 2020

3 Cited Research Articles

  1. U.S. Internal Revenue Service. (2020, January 15). Simplified Employee Pension Plan (SEP). Retrieved from https://www.irs.gov/retirement-plans/plan-sponsor/simplified-employee-pension-plan-sep
  2. U.S. Internal Revenue Service. (2019, December 4). SEP Plan FAQs. Retrieved from https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-seps
  3. U.S. Securities and Exchange Commission. (n.d.). Individual Retirement Accounts. Retrieved from https://www.investor.gov/additional-resources/retirement-toolkit/self-directed-plans-individual-retirement-accounts-iras