What is a SEP IRA and Who Can Open One?

You’ve probably heard of Traditional IRAs and Roth IRAs, but what about a SEP IRA? A SEP IRA is a tax-deferred retirement plan for anyone who owns a business, is self-employed, earns freelance income, or employs others. Does this sound like you? If so, you might be interested in learning more about this retirement account option.

What is a SEP IRA?

SEP IRA stands for Simplified Employee Pension Individual Retirement Account. Like a traditional IRA, SEP IRA contributions are tax-deductible and distributions are taxed at retirement. A SEP IRA is a simple way to save for retirement.

This type of IRA is usually best for self-employed individuals or businesses with very few employees. Contributions for employers and employees must be in the same percentage of earnings (up to the limit). This means that a business owner who wants to take advantage of a SEP IRA must contribute for eligible employees as well. 

Who Can Open a SEP IRA?

An employer can open a SEP IRA for themselves and for each participating employee. An employee must be included in the SEP IRA program if they meet three criteria. The employee must be 21 years of age and have worked for your business three out of the last five years. They must also make at least $600 in total yearly compensation from your business. To put it another way, a business owner has to open a SEP IRA account for any employee who meets these criteria if they want to open one for themselves.

The criteria for SEP IRA participation applies to business owners as well as employees. Each individual owner and employee will have their own SEP IRA account. If two spouses own the business, for example, each person has an individual SEP IRA. 

According to the IRS, a business owner may choose to allow other employees (who don’t meet these criteria) to participate in the program. An individual business may decide to impose less restrictive participation criteria but cannot choose more restrictive criteria. For example, they may choose to open a SEP for an employee who is 18 and not 21.

How Much Can I Contribute to My SEP IRA?

The real value of a SEP IRA is in the contributions. You can contribute 25% of your total compensation for the calendar year or up to $56,000 (for 2019), whichever is less. And, when a business is contributing on behalf of their employees, each employee must receive the same percentage contribution, proportional to their earnings. Here’s a simple example:

Joan owns a coffee shop. She decides to contribute 25% to a SEP IRA program.

  • Her employee, Jim, earns $20,000 per year at the coffee shop. He receives a $5,000 contribution.
  • Her employee, Sue, earns $30,000 per year. She receives a $7,500 contribution.
  • Joan herself earns $250,000 per year from the coffee shop. Twenty-five percent of $250,000 is $62,500, so Joan is subject to the cap and contributes $56,000 for herself. 

Self-employed individuals use a special calculation to determine how much they can contribute. If you’re self-employed, you can only contribute if you have net positive earnings from the business for which the SEP plan was established. The earnings must be from your personal services provided, not from investments. If you experienced a net loss from self-employment, you are not eligible to contribute to a SEP IRA. 

SEP IRAs are worth taking advantage of if you qualify because the contribution limits are so much higher than those of Traditional and Roth IRAs. The contribution limit across Traditional and Roth IRAs is $6,000 per year in 2019 for people under 50. This number is tiny relative to the contribution limits for SEP IRAs. 

How Do I Open a SEP IRA?

Most online brokerage firms, banks, and financial institutions offer SEP IRA accounts. If they offer Traditional IRA and Roth IRA accounts, they also probably offer SEP IRA accounts. 

When you’re ready to open SEP IRA accounts for yourself and your employees, you need to follow the process specified by the IRS to make sure you’re following the tax rules correctly. First, you’ll execute a written agreement to provide benefits to all employees who are eligible. The agreement should include the business name, participation criteria (not more restrictive than the criteria provided by the IRS) and a formula to define contributions. The agreement must be signed by a responsible company official. 

Next, you need to provide information about the SEP IRA to your employees. Let them know that you have established a SEP IRA program. Tell them the requirements for participation and how the employer contribution will be determined, in accordance with the written agreement. Employers must also give employees certain notices about the plan administration, following IRS guidelines. 

Finally, you need to set up a SEP IRA account for each employee who is eligible. The employer is responsible for opening the account and contributing to the account as defined by their plan. Employees are responsible for making all investment decisions related to their SEP IRA. 

What Kinds of Investments Can I Make With a SEP IRA?

Like any other retirement or investment account, you can buy an assortment of financial instruments with funds in a SEP IRA. This typically includes stocks, bonds, index funds, and mutual funds. 

When you’re deciding how to invest your SEP IRA contributions, you should think about your overall financial goals. How old are you and how soon do you expect to retire? What is your tolerance for risk? If you have a longer time to retirement and are willing to absorb some losses, your portfolio can be weighted toward higher risk (and potentially higher return) stocks

If you’re closer to retirement or more risk-averse, you may not want to risk losing money. In that case, consider including more conservative, diversified funds in your portfolio.

Regardless of what you choose to invest in, know that most investment instruments do carry some risk of loss. The key is to balance the risk and plan accordingly.

What Are the Pros and Cons of a SEP IRA?

If you’re eligible, a SEP IRA has some major benefits. Of course, there are also some downsides.

Pros of a SEP IRA

  • High contribution limit of $56,000 relative to Traditional/Roth IRA contribution limit of $6,000
  • Simple for employers to administer
  • Flexible for employers because contributions are not required every year
  • Tax-deductible contributions, including those made to employee accounts (Note that self-employed individuals have a different deduction calculation)

Cons of a SEP IRA

  • Employers must contribute to employees’ SEP IRAs if they want to contribute to their own. Business owners aren’t allowed to save only for their own retirement if they have employees.
  • Tax deductions for self-employed individuals require additional calculations.
  • No catch-up contributions allowed for those aged 50 or older
  • Early withdrawals (prior to age 59 ½) are taxed as income, plus subject to a 10% penalty.

The Bottom Line

If you’re self-employed or own a business with few eligible employees, opening a SEP IRA is a helpful addition to your retirement savings plan. Since the SEP IRA contribution limit is so much higher than the limit for a Traditional or Roth IRA, you can save an additional $56,000 per year tax-deferred. A SEP IRA program is also a great way to support your employees’ retirement savings and may be an enticing benefit to offer. Make sure to follow the IRS rules carefully when you establish your SEP IRA and from there, it’s simple to manage and beneficial to your retirement nest egg.