SEP IRAs: Pros and Cons

When you run a business, a company-sponsored retirement plan is a great way to attract top talent. Traditional retirement accounts can come with high costs, a significant administrative burden and restrictive contribution rules — a deterrent for small businesses, seasonal companies and independent contractors. If that sounds familiar, a simplified employee pension individual retirement account (SEP IRA) may be a convenient alternative.

Learn More About Medicare

Join our email series to receive your free Medicare guide and the latest information about Medicare.

Leave this field empty Sign me up!

By clicking "Sign me up!" you are agreeing to receive emails from HelpAdvisor.com

Thanks for signing up!

Your free Medicare guide is on the way.

Make sure to check your spam folder if you don't see it.

What Is a SEP IRA?

A SEP IRA is a retirement account that any employer, including self-employed professionals, can set up to benefit themselves and their employees. SEP IRAs are easier and less expensive to establish than other types of IRAs; they also offer more flexibility in terms of how much you can contribute.

The original intent of the SEP IRA was to give small businesses a viable way to offer retirement benefits; in 1981, this type of account became available to every business owner.

How is a SEP IRA different from a traditional IRA?

SEP IRAs and traditional IRAs are both types of retirement accounts, but they have a few key differences.

SEP IRA Eligibility, Contribution and Withdrawal Rules

In comparison to other retirement accounts, SEP IRAs are relatively easy to establish. The basic steps are:

• Create a written agreement that lays out the requirements for participation.
• Notify eligible workers about the plan, requirements and contribution rules.
• Open an approved IRA for every participating employee.

Once the accounts are up and running, all you need to do is contribute money and deduct that amount on your taxes — there are no complicated filing requirements.

Who Can Participate in a SEP IRA?

Before an employee can participate in a SEP IRA, they must:

• Be 21 or older.
• Have worked for the company for a minimum of 3 years in the last 5 years.
• Meet minimum annual income requirements.

As the employer, you have a certain level of flexibility; you can opt for lower age, employment duration or income levels. In addition, you aren't required to offer these accounts to nonresident aliens or union members with an existing retirement agreement.

SEP IRA Contribution Limits

SEP IRAs are known for their high contribution limits and flexible options. When you contribute to an employee's SEP IRA, the amount is based on a percentage of the account owner's income. The IRS requires you to contribute the same percentage to every account, including your own.

Additional rules:

• You must contribute by the date your tax return is due.
• You aren't required to make contributions every year.
• The standard contribution limit is the lesser of $66,000 per year or 25% of the person's annual compensation (up to $330,000).
• You can deduct the standard contributions you make.
• Excess contributions are treated as income and taxed accordingly.

If you have an employee who makes $30,000, you could contribute up to 25% or $7,500. For a person making $310,000 per year, the limit would be $66,000 — 25% of their income is $77,500, which is over the threshold.

Self-employed individuals can still deduct contributions, but the rules change slightly. To find your maximum deduction, subtract your personal SEP IRA contributions and half of your self-employment tax amount from your total net self-employment income.

There are no tax-filing requirements for money you contribute to SEP IRAs; you don't need to include the amounts on W-2 forms. However, you should indicate that you provide a retirement plan.

SEP IRA Withdrawal Rules

If you're familiar with other IRAs, the withdrawal rules will sound familiar:

• Account owners can withdraw funds at any time.
• Withdrawals before age 59.5 are subject to income tax and an additional 10% tax.
• You may not take participant loans on a SEP IRA.
• Required minimum distributions start at age 72.

Is a SEP IRA Tax-Free?

A SEP IRA isn't tax-free, but contributions are tax-deductible for employers, and earnings are tax-deferred for employees. If you own a SEP IRA account, you can roll it over tax-free to another retirement account.

Can I Cash Out My SEP IRA?

You can cash out your SEP IRA whenever you like, but you can expect to pay income tax on the money, as well as a potential 10% penalty for early withdrawal. If your income tax rate is 20% and you're younger than 59.5, you'd pay 30% to cash out.

Pros and Cons of SEP IRAs

Like any retirement account, a SEP IRA comes with both advantages and disadvantages. The benefits may vary based on your business, financial situation and number of employees. 

Advantages of SEP IRAs

• Quick and easy setup process
• High contribution limit of up to $66,000
• No requirement to contribute each year
• Tax-deductible contributions
• Tax-deferred growth
• No complicated filing requirements
• Can be rolled over tax-free to another retirement account

Disadvantages of SEP IRAs

• Don't allow employee contributions
• Must contribute the same percentage to each SEP IRA (including your own)
• Withdrawals are subject to income tax
• Early withdrawals have a 10% tax penalty 
• No catch-up contributions
• No participant loans

Who Can Benefit From a SEP IRA?

SEP IRAs are an attractive option if you're self-employed or a sole proprietor — they enable you to save more for retirement than a traditional IRA. Plus, you can take contributions as a tax deduction and defer the taxes on the interest you earn over time.

In general, SEP IRAs are best suited to very small companies. This is largely due to the contribution requirements — you must give the same percentage to every participating employee. The more workers you have, the more expensive the program becomes.

Does your business fluctuate dramatically from season to season or year to year? You might benefit from the flexible contribution rules of a SEP IRA. In slow years, you can reduce or pause contributions without closing the account.