Want to save for retirement as a self-employed worker, and get similar tax benefits as employees with retirement plans?
The simplified employee pension individual retirement account — or SEP IRA as less of a mouthful — helps you do just that. All without the red tape and expenses of a solo 401(k).
What Is a Simplified Employee Pension (SEP) IRA Retirement Account?
As the name suggests, a SEP IRA is a type of IRA. It serves as a tax-advantaged account where you can invest in stocks, bonds, ETFs, mutual funds, REITs, and other publicly-traded assets.
You can open a SEP IRA with a traditional investment brokerage, such as T. Rowe Price, Fidelity, or Vanguard. You control your own investments, and can log in to contribute funds and trade any investments available through your brokerage.
The federal government designed these accounts specifically for retirement, and doesn’t allow you to withdraw money until you reach retirement age.
SEP IRA Rules
Like other tax-sheltered brokerage accounts, SEP IRAs come with plenty of rules and restrictions. Make sure you understand them before creating an account or contributing funds.
Eligibility
To begin with, you must be self-employed to open a SEP IRA. That includes small-business owners, freelancers, gig economy workers, and other self-employed individuals.
However if you run a business with employees and open a SEP IRA for yourself, you must also allow your employees to participate. In fact, you have to contribute the same percentage of their income to their SEP IRA account as the percentage of your income that you contribute to your own account.
For example, if you contribute 10% of your income to your SEP IRA, you must also contribute 10% of each qualifying employee’s income to their SEP IRAs too.
That means SEP IRAs work best for solopreneurs with no employees. They also serve well for small family businesses, where you don’t mind shelling out employer contributions for your children’s retirement accounts.
Eligible employees include those 21 years of age or older, who earn at least $650 per year, and who aren’t covered under a collective bargaining agreement. You also don’t have to contribute for nonresident workers in other countries.
You also don’t have to commit to a certain contribution percentage each year. In a down year for your business, you can contribute less — or nothing — to your and your employees’ SEP IRAs.
Tax Benefits
You score an immediate tax deduction this year for the amount you contribute to your SEP IRA. In that sense, the tax deductions work like traditional IRAs or 401(k)s.
However unlike those accounts, there’s no Roth option for SEP IRAs. You don’t have the option to pay taxes on SEP IRA contributions now, in exchange for tax-free compounding and paying no taxes on withdrawals in retirement.
That said, you can contribute to a SEP IRA and then later roll over funds to your Roth IRA, as a backdoor Roth contribution.
Contribution Limits
You may contribute up to 25% of your self-employed income to a SEP IRA. The IRS caps your annual contribution at $58,000 for tax year 2021, and $61,000 for 2022. The IRS does not impose income limits for eligibility: you can contribute up to the maximum amount and deduct it, regardless of how much you earn.
For most Americans, that makes SEP IRAs a more flexible option than traditional IRAs, allowing a higher contribution.
Note that you can contribute to both a SEP IRA and a traditional or Roth IRA in the same year.
Unlike traditional and Roth IRAs however, SEP IRAs do not offer a higher catch-up contribution allowance for workers age 50 and over.
Withdrawals and Required Minimum Distributions (RMDs)
Because SEP IRAs give you an immediate tax deduction on your contribution, you must pay taxes on withdrawals in retirement.
If you withdraw money before age 59 ½, the IRS hits you with a 10% early withdrawal penalty plus taxes on the withdrawal, just like traditional IRAs.
And like traditional IRAs, you must start taking required minimum distributions (RMDs) by age 72. The better to tax you with, my dear.
Deadlines
You can contribute to your SEP IRA up until the tax filing deadline, usually April 15. That gives you time to prepare your tax return for the previous year before deciding how much to contribute.
Beware that filing for an extension on your tax return deadline does not change your contribution deadline however.
Pros and Cons of SEP IRAs
Small-business owners have several options available to them for retirement plans, from SIMPLE IRAs to 401(k)s and beyond.
Before you settle on a SEP IRA, make sure you understand how the pros and cons of each compare.
Pros of SEP IRAs
For the right type of self-employed worker, SEP IRAs offer tempting benefits.
- High contribution limits. While traditional and Roth IRAs allow only $6,000 in annual contributions for workers under 50, you can contribute up to $61,000 in 2022.
- Contribute to multiple accounts. Why choose? You can contribute to both your SEP IRA and a Roth or traditional IRA if you like.
- Flexible investment options. Because you open and manage your SEP IRA through a regular investment broker, you can invest in nearly any publicly traded asset.
- Easy to open and administer. Unlike 401(k)s, SEP IRAs come with virtually no administrative headaches or fees.
- Flexible contributions. You choose how much you want to invest each year, without being locked into a percentage.
Cons of SEP IRAs
Like all investment and retirement accounts, SEP IRAs come with their fair share of downsides.
- Must offer to qualifying employees. Whatever percentage of your own income you contribute, you must match the same percentage for each employee. That makes SEP IRAs impractical for most businesses with employees.
- No loans. Unlike 401(k)s, you can’t borrow money against your SEP IRA balance.
- No Roth option. You can’t opt to pay income taxes on contributions now, in favor of tax-free growth and withdrawals in retirement.
- No higher catch-up contribution limit. Older workers can’t contribute more to catch up on their retirement savings.
- Required minimum distributions. Starting at age 72, you need to start draining your SEP IRA and paying taxes on withdrawals.
Final Word
For sole proprietors, business partners with no employees, and small family businesses, SEP IRAs can offer the perfect retirement plan. You benefit from high contribution limits while maintaining full control over your investments, and avoid the administrative headaches and fees of 401(k)s.
But as you add employees, beware that you have to cough up money for their retirement accounts too. Speak with a tax advisor before setting up a SEP IRA plan for your business.
Still, the combined perks make SEP IRAs a streamlined and savvy way for entrepreneurs and freelancers to save for retirement.
