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The ultimate guide to starting a SEP IRA
IRA Savers

The ultimate guide to starting a SEP IRA

Nicolle Willson, J.D., CFP®, C(k)P®

What is a SEP IRA?

A Simplified Employee Pension (SEP) IRA is a type of individual retirement account where contributions are made by the employer only. SEPs are tax-deferred retirement plans that may be established by businesses of any size. They are popular with entrepreneurs and small businesses owners due to larger contribution limits, greater flexibility, and fewer administration requirements compared to other retirement plans.

If you own a company without many employees and want a stress-free, flexible way to contribute to retirement, a SEP IRA may be the right choice for you.

Who can establish a SEP IRA?

Any business owner, including self-employed individuals or anyone with freelance income, can open a SEP IRA. They require less paperwork than other retirement plans, and opening an account can be easily accomplished by filling out a form online.

SEP IRA rules for contributions

Understanding the rules for SEP IRA contributions is key to a smooth-running account. Contributions are made by the employer only and must be equal as a percentage of compensation across the entire employee pool. Since employer/owners are also considered employees of the company, they must receive the same percentage of salary as all other employees.

For example, if an employer/owner contributes 20% of their compensation to their own retirement under a SEP IRA, they must also contribute 20% of each eligible employee's compensation. This makes a SEP IRA a great option for small businesses or family-owned businesses that want to share profits and also save for retirement. Those with a larger staff may find another type of retirement plan to be a better fit due to the funding requirements.

Eligible participants

Eligible participants are employees who:

  • Are 21 years old or older
  • Have worked for you at least three of the past five years
  • Have earned at least $650 in compensation from the employer in the past year

These SEP IRA rules are set by the IRS but may be lowered if the employer chooses. For example, an employer has the option to decrease the age restriction to allow an 18-year-old to participate or set the earnings minimum to $300 per year to allow additional employees to benefit.

Contributions can be made at the employer’s discretion. There is no requirement regarding when and how many times a business owner can contribute as long as all contributions for the tax year in question are submitted by the tax return due date. Because contributions are not tied to payroll processing, employers can make a contribution via their plan provider’s online portal, phone, or mail.

SEP IRA benefits

Contribution flexibility

When it comes to SEP IRA benefits, the biggest ones for small business owners are typically flexibility and ease. With this option, you can contribute as much as you choose (subject to IRS limits) whenever you want. Contributions need to be made by the tax deadline of that year and must be equal as a percentage of compensation across the entire employee pool.

This means the business owner can delay making a decision on how much to contribute for the tax year in question until the filing deadline the following year. Since the amount is not guaranteed from year to year, employers can increase or decrease their contributions with the ebb and flow of business revenue.

Administration ease and affordability

SEP IRA plans require very little administrative effort. Other types of retirement plans, such as a 401(k), require non-discrimination testing on an annual basis and will need to have a 5500 tax filing prepared annually. This type of tax filing typically places a great deal of reporting risk on the preparer and can therefore cost thousands of dollars every year.

Another administrative SEP IRA benefit is the lack of required annual employee notices. 401(k) plans often require documents such as Safe Harbor Notifications to be delivered to each employee by a precise due date each year. With SEP IRA plans, employers generally face no annual filing requirements.

Employers are, however, required to provide certain notices to employees, including:

  • A copy of Form 5305-SEP and the other documents and disclosures listed in the Form’s instructions
  • Notice of any amendments to the SEP and changes to the requirements for receiving contributions
  • An annual contribution statement

At Guideline, we handle all of this paperwork for you.

Higher contribution limits

Typically, the No. 1 reason a business owner will choose a SEP IRA over a traditional or Roth IRA is the higher contribution limits of SEP plans. For years 2019-2021, individuals cannot have more than $6,000 ($7,000 if over the age of 50) contributed to their traditional or Roth IRA. With a SEP account, however, the limit is up to the smaller amount of either 25% of a person’s annual compensation or $58,000 (as of 2021). This is increasing to $61,000 in 2022.

As an additional bonus, a person is allowed to max out both a SEP IRA and a traditional or Roth IRA within the same year. So in 2021, if you are a small employer with a SEP plan, you can contribute the full $58,000 (if your compensation is at least $232,000) and also max out your traditional or Roth IRA. This means you can put away up to $64,000 or $65,000 each year toward retirement as opposed to $6,000-7,000 with an IRA alone.

Disadvantages of a SEP IRA

Cost for larger businesses

There are a few reasons why a small business owner may want to choose a different type of retirement account. The biggest reason is the equal contribution requirement for the employer and employees. Only employers can contribute to a SEP IRA, and they must contribute the same percentage of salary for any eligible employees as they do for themselves. For employers who have a large amount of employees, this can be a deal breaker.

For example, let’s say a small business owner earns $225,000 in compensation a year, with two employees who earn $40,000 in compensation per year. For the owner to contribute the maximum amount of $56,250 (as this amount is the lesser of $58,000 or 25% of annual compensation) to a SEP account, the owner would also need to contribute 25% for each of the employees, costing an additional $20,000. If the owner has 20 employees who earn $40,000 in compensation, that additional amount for employees increases to $200,000 just to get $56,250 for the owner.

Less calculation flexibility

Contribution percentages are firm and cannot vary across employees with a SEP IRA. By comparison, a 401(k) plan could allow the owner to make a discretionary match that follows alternate calculations based on such things as employee age, department, or salary level.

No catch-up contributions allowed

Catch-up contributions (additional allowable contributions for individuals age 50 or older) are not available with a SEP IRA. This differs from the contribution limit rules for IRA and 401(k) plans. The lack of catch-up contributions is only a minor disadvantage, however, since the plan allows for greater contributions in total than those that allow the additional catch-up funds.

Hardship distributions and loans not allowed

401(k) plans have the option of allowing hardship distributions and/or loans from an employee’s 401(k) account. A hardship distribution is when a participant withdraws, without penalty, an amount from their retirement account to satisfy an urgent financial need related to specific reasons. SEP IRAs do not allow hardship distributions, and any funds withdrawn before the age of 59½ are subject to a 10% tax penalty, even if they are used for a hardship.

Loans from an employee’s account are also not allowed from SEP IRAs. Some employers may consider this a benefit, as 401(k) plan loans require a great deal of oversight and documentation. Because SEP IRAs do not allow this feature, it can decrease the administrative burden on the employer.

SEP IRAs vs. other retirement plans

SEP IRA vs. 401(k)

It can be difficult for small businesses to choose between a 401(k) and a SEP IRA. In the end, it depends on the size of your business and your needs and circumstances. For self-employed individuals with a high income, a SEP IRA offers a convenient way to save for retirement that can be easier and more affordable than other options. Those with a side gig who already contribute to an employer-sponsored 401(k) or other retirement plan may also benefit.

A 401(k) may be a better option for businesses that have many employees or plan to increase its number of employees. Since employers are required to make equal contributions to all eligible employees, a SEP IRA can get costly quickly if there are a large number of employees . A 401(k) may also be a better option for business owners who want to allow employees to save for their own retirement from their paychecks.

SEP IRA vs. IRA (Traditional and Roth)

The biggest benefit of choosing a SEP IRA instead of a traditional or Roth IRA is the higher contribution limit. With a SEP IRA, you can set aside the lesser of 25% of your compensation or a maximum of $58,000 each year for 2021 ($61,000 in 2022). The contribution limits for traditional and Roth IRAs are much smaller at $6,000 per year (or $7,000 if you’re age 50 or older). SEP IRAs also allow for employer contributions, whereas traditional and Roth IRAs do not. SEP contributions are tax-deductible for business owners who open accounts.

Anyone can open a traditional or Roth IRA account. In fact, you can technically have all three accounts if you meet the qualifications. With a traditional IRA account, like a SEP account, your contributions are pre-tax. That means you pay no taxes up front, but when you withdraw money for retirement, it will be taxed as ordinary income.

Roth IRAs consist of after-tax contributions so they are not taxed as ordinary income when withdrawn after retirement. However, they also have an income limit. To be eligible to contribute to a Roth IRA in 2021, single tax filers must have a gross income of $140,000 or less ($144,000 in 2022), and married filers must have a household income of $208,000 or less ($214,000 in 2022).

Setting up a SEP IRA

As an employer, opening a SEP IRA is very simple. First, you need to choose a plan provider. When you contact a plan provider, they will ask you to complete your plan setup by filing paperwork online, by mail, or in person. After you’ve finished setting up a SEP IRA, you will need to alert all eligible employees. Once your employees set up their accounts, you’ll be ready to start making contributions.

How to choose a SEP IRA plan provider

What to look for in a provider

Select a plan and provider that align with your business goals. There are three main areas we suggest you keep in mind: setup, cost, and investment options.

When it comes to plan setup, a key benefit of SEP IRAs is that they are easy to open and manage. When choosing a provider, look for one that provides a seamless, user-friendly experience. This includes great customer service, a setup process that is quick and easy, and a low-maintenance plan. Does the plan provider make it easy to roll over a previous retirement account? Is there a dashboard where you and your employees can check your balance, make contributions, and see your investments?

A major draw of SEP IRAs is their affordability, but administrative costs among providers vary. Look out for additional fees such as deposit fees, withdrawal fees, investment management fees, and account maintenance fees.

There are many different types of investment options a plan provider might offer to users. Ask yourself how hands-on you’d like to be. Would you rather hand-select from an array of stocks, bonds, and mutual funds? If so, look for self-directed accounts. If you want something simpler to manage, a provider that offers managed portfolios may be a better fit.

How and why to sign up with Guideline

At Guideline, our SEP IRAs offer professionally managed portfolios with automatic rebalancing. They are easy to set up, manage, and get support for when needed — all for just $8 a month plus a 0.08% annual account fee. You can open your account in about 10 minutes and start investing in your future.

Open a Guideline SEP IRA

Frequently asked SEP IRA questions

Can I have a SEP IRA and a 401(k)?

Yes, you can have both a SEP IRA and a 401(k), as long as they are operated by two unrelated employers. For example, if you have both regular employment and self-employed income, you are allowed to save with both. You could contribute to your 401(k) through your regular paycheck and set up a SEP IRA for additional savings from your self-employed business income.

Can I have a SEP IRA and a traditional IRA?

Yes, you can have both a SEP IRA and a traditional IRA.

Can a SEP IRA be rolled into an IRA?

You can convert your SEP IRA into a traditional IRA by rolling over your funds. However, a SEP IRA to Roth IRA conversion may be trickier. A SEP IRA is a pre-tax retirement account, while a Roth IRA is a post-tax account. Ask your plan provider if this type of rollover is accepted; if so, they should be able to walk you through the process.

Can a SEP IRA be rolled into a 401(k)?

Yes, you can roll over your SEP IRA account into a 401(k) and vice versa, if the 401(k) plan allows it.

How are SEP IRAs taxed?

Most of the tax rules for traditional IRAs also apply to SEP IRAs. Employer contributions are tax-deductible, as subject to the IRS Internal Revenue Code. The most you can deduct on your business's tax return for contributions to your employees' SEP IRA is the lesser of your contributions or 25% of compensation.

What are the basic withdrawal rules?

Withdrawal rules for SEP IRAs are the same as withdrawal rules for traditional IRAs. You can take income from your SEP IRA at any time; however, it will be subject to an additional 10% tax if you withdraw before age 59½.